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BUSINESS ECONOMICS
www.eiilmuniversity.ac.in
Subject: BUSINESS ECONOMICS Units: 4
SYLLABUS
Introduction to Business Economics, Scarcity, Choice and Efficiency, Demand Analysis, Supply
Analysis, Equilibrium of Supply and Demand, Elasticity of Supply and Demand
Utility Approach, Preference Approach in the context of consumer choice, Indifference Curve, Price
Effect and Consumer Surplus
Theory of Firm, Firm and its Production, Law of Variable Proportions, Cost Analysis, Economies of
Scale
Perfect Competition, Monopoly, Imperfect Competition, Monopolistic Competition, The Role of
Government in the Market Economy, Pricing Strategy, Acquiring and Using Market Powers, Natural
Monopoly, Profit Maximization and the Perfectly Competitive Firm
Demand and Supply in Factor Market, Labour, Land, Capital and Natural Resources, Income and
Wealth
Suggested Readings:
1. Karmel, P.H. & Polasek, M.: Applied statistics for economists
2. Spiegel, M.R.: Theory & Problems of Statistics, Schaum’s outline series, McGraw Hill ub.Co.
3. Spiegel, M.R.: Probability and Statistics
4. Freund: Mathematical Statistics
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Economics has proved itself as a basic discipline; its application
has a wide range. New areas of application are continuously
being discovered where the principles, tools and techniques of
economics are being used as the logic of reasoning in business.
Without the knowledge and understanding of economics, no
business, government, nation, any international body or for
that matter any organization, including the NGOs, can function
in today’s world.
In other I can say that there’s a need for basic training in
economics followed by application in evaluating the rationality
and optimality of business decisions taken by any agent. Hence,
you being the student of BBA need this training. Therefore,
this subject “Business Economics” is included in your curricu-
lum.
The students on completion of the course shall develop the
following skills and competencies:
1. Examine concepts and analysis of basic business
economics
2. Investigate the behaviour of economic agents in the
consumer markets in the context of market relationships.
3. Understand the various aspects of the business
organization in the light of the managerial decision-making.
4. Develop a critical awareness of the various market
structures aimed at tackling price and output determination.
BUSINESS ECONOMICS
COURSE OVERVIEW
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S-I. Lesson No. Topic Page No.
Lesson 1 Introduction to Business Economics 2
Lesson 2 Scarcity, Choice and Efficiency 7
Tutorial 1 15
Lesson 3 Demand Analysis 18
Lesson 4 Supply Analysis 21
Lesson 5 Equilibrium of Supply and Demand 24
Lesson 6 Elasticity of Supply and Demand 28
Tutorial 2 32
Lesson 7 Consumer Behaviour – I (Utility Approach) 38
Lesson 8 Consumer Behaviour – II Preference Approach 45
Lesson 9 Consumer Behaviour – III Indifference Curve 52
Lesson 10 Consumer Behaviour – IV Price Effect and Consumer Surplus 58
Tutorial 3 63
Lesson 11 The Firm and its Production 66
Lesson 12 Law of Variable Proportions 74
Lesson 13 Theory of Firm 78
Lesson 14 Applications of Theory of Production 84
Lesson 15 Cost Analysis - I 89
Lesson 16 Cost Analysis - II 95
Lesson 17 Economies of Scale 101
Tutorial 4 106
Tutorial 5 108
Lesson 18 Perfect Competition 115
Lesson 19 Monopoly 120
Lesson 20 Imperfect Competition 126
Lesson 21 Monopolistic Competition 129
Lesson 22 The Role of Government in the Market Economy 139
CONTENT
BUSINESS ECONOMICS
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CONTENT
BUSINESS ECONOMICS-I
Lesson 23 Pricing Strategy 125
Lesson 24 Acquiring and Using Market Powers 148
Lesson 25 Natural Monopoly 155
Lesson 26 Profit Maximization and the Perfectly Competitive Firm 158
Lesson 27 Demand and Supply in Factor Market 167
Tutorial 6 170
Lesson 28 Labour 174
Lesson 29 Land, Capital and Natural Resources 175 Lesson 30 Income and Wealth 182
Tutorial 7 193Essential Principles 194Glossary 196Reference Material 199
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BASIC BUSINESS ECONOMICSCHAPTER 1:
THE FUNDAMENTALS OF ECONOMICS
Economics has been recognized as a special area of study forover a century. Virtually all four-year colleges offer courses ineconomics and most allow students to major in the subject.Economists maintain high profiles in governments, and theyhave been well-represented among the highest appointees in thefederal government of the United States. The press reports ontheir doings and sayings, sometimes with praise and admira-tion, sometimes with ridicule and scorn. Economics andeconomists are words that almost everyone has heard of anduses. But what exactly is economics? Very few people can give agood definition or description of what this field of study is allabout.If ordinary citizens cannot give a good definition or descriptionof economics, they can be excused because economists longstruggled to define their field. In addition, in recent years, thesubject matter that economists have studied has expanded,making its boundaries less defined. In recent years, for example,economic journals have published papers on topics such as sex,crime, slavery, childbearing, and rats. It is not surprising, then,that one economist, in a lighter moment, suggested thateconomics can be defined as “what economists do.”Defining economics as “what economists do” does not tell usanything we did not already know. A good definition mustexplain what it is that makes economics a distinct subject,
different from physics or psychology. One should not expect tofind a short definition that conveys with absolute clarity all thereis to know about economics (or else there would be no reasonto spend hours learning about it). Neither should one believethat there is only one correct definition possible. Many gooddefinitions are possible, and each will focus on some importantaspect of the subject. To use an analogy, there is not one spotfrom which one can best view Niagara Falls. Each viewpointobscures some features and emphasizes others. There are, ofcourse, some spots that are clearly superior to others, butpeople can disagree about which is the very best spot.This group of readings examines definitions of economics andexplains what those definitions mean.After you finish this chapter, you should be able to:• Explain what the term “invisible hand” means and who first
used it.• Give at least one common definition of economics.• State what Malthus thought about population growth.• Explain how Popper defines scientific statements.• Distinguish between positive and normative statements.• Explain what scarcity, choice, and self-interest have to do
with economics.
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LESSON 1:INTRODUCTION TO BUSINESS ECONOMICS
As the title suggests, the purpose of this lesson is to help youunderstand what economics is about and what you can hope tolearn by undertaking a study of economics. Since you will learnwhat economics is about as you progress through the course,you might wonder if this lesson is really important. The degreeof success that you will experience in your study of economicswill be determined, to a large extent, by your motivation andyour intent to learn. People generally learn more when theirstudy is being carried out with a particular intent. In the firsthalf of this lesson you will read about various economicproblems and ideas. You will probably find at least some of theproblems and ideas to be interesting. You may then studyeconomics with an intent to acquire knowledge and reasoningabilities that will help you to understand these ideas and solvethese problems.
1.1 What is economics ?One of the earliest and most famous definitions of economicswas that of Thomas Carlyle, who in the early 19th centurytermed it the “dismal science.” What Carlyle had noticed was theanti-utopian implications of economics. Many utopians, peoplewho believe that a society of abundance without conflict ispossible, believe that good results come from good motivesand good motives lead to good results. Economists havealways disputed this, and it was the forceful statement of thisdisagreement by early economists such as Thomas Malthus andDavid Ricardo that Carlyle reacted to.Another early definition, one which is perhaps more useful, isthat of English economist W. Stanley Jevons who, in the late19th century, wrote that economics was “the mechanics ofutility and self interest.” One can think of economics as thesocial science that explores the results of people acting on thebasis of self-interest. There is more to man than self-interest,and the other social sciences—such as psychology, sociology,anthropology, and political science—attempt to tell us aboutthose other dimensions of man. As you read further into thesepages, you will see that the assumption of self-interest, that aperson tries to do the best for himself with what he has,underlies virtually all of economic theory.At the turn of the century, Alfred Marshall’s Principles ofEconomics was the most influential textbook in economics.Marshall defined economics as “a study of mankind in theordinary business of life; it examines that part of indi-vidual and social action which is most closely connectedwith the attainment and with the use of the materialrequisites of wellbeing. Thus it is on one side a study ofwealth; and on the other, and more important side, a partof the study of man.”Many other books of the period included in their definitionssomething about the “study of exchange and production.”Definitions of this sort emphasize that the topics with whicheconomics is most closely identified concern those processes
involved in meeting man’s material needs. Economists todaydo not use these definitions because the boundaries ofeconomics have expanded since Marshall. Economists do morethan study exchange and production, though exchange remainsat the heart of economics.Most contemporary definitions of economics involve thenotions of choice and scarcity. Perhaps the earliest of these is byLionell Robbins in 1935: “Economics is a science whichstudies human behavior as a relationship between ends andscarce means which have alternative uses.” Virtually alltextbooks have definitions that are derived from this definition.Though the exact wording differs from author to author, thestandard definition is something like this: “Economics is thesocial science which examines how people choose to uselimited or scarce resources in attempting to satisfy theirunlimited wants.”In other words “Economics is the science of choice — thescience that explains the choices that we make and how thosechoices change as we cope with scarcity.”By now you must have got an idea that scarcity is central inthese definitions. Now let’s examine scarcity.
1.2 Scarcity and ChoiceScarcity means that people want more than is available. Scarcitylimits us both as individuals and as a society. As individuals,limited income (and time and ability) keep us from doing andhaving all that we might like. As a society, limited resources(such as manpower, machinery, and natural resources) fix amaximum on the amount of goods and services that can beproduced.Scarcity requires choice. People must choose which of theirdesires they will satisfy and which they will leave unsatisfied.When we, either as individuals or as a society, choose more ofsomething, scarcity forces us to take less of something else.Economics is sometimes called the study of scarcity becauseeconomic activity would not exist if scarcity did not force peopleto make choices.When there is scarcity and choice, there are costs. The cost ofany choice is the option or options that a person gives up. Forexample, if you gave up the option of playing a computer gameto read this text, the cost of reading this text is the enjoymentyou would have received playing the game. Most of economicsis based on the simple idea that people make choices bycomparing the benefits of option A with the benefits ofoption B (and all other options that are available) and choosingthe one with the highest benefit. Alternatively, one can view thecost of choosing option A as the sacrifice involved in rejectingoption B, and then say that one chooses option A when thebenefits of A outweigh the costs of choosing A (which are thebenefits one loses when one rejects option B).
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The widespread use of definitions emphasizing choice andscarcity shows that economists believe that these definitionsfocus on a central and basic part of the subject. This emphasison choice represents a relatively recent insight into whateconomics is all about; the notion of choice is not stressed inolder definitions of economics. Sometimes, this insight yieldsrather clever definitions, as in James Buchanan’s observationthat an economist is one who disagrees with the statement thatwhatever is worth doing is worth doing well. What Buchanan isnoting is that time is scarce because it is limited and there aremany things one can do with one’s time. If one wants to do allthings well, one must devote considerable time to each, andthus must sacrifice other things one could do. Sometimes, it iswise to choose to do some things poorly so that one has moretime for other things.
1.3 What Is A Science?Should we accept claims of economists who say they arescientists? To decide, we must first know what science is.Philosopher Karl Popper’s widely accepted definition of sciencesays that a statement is scientific only if it is open to the logicalpossibility of being found false. This definition means that weevaluate scientific statements by testing them, by comparingthem to the world about us. A statement is nonscientific if ittakes no risk of being found false; that is, if there can be no wayto test the statement against observable facts or events. Poppercalled this distinction the “line of demarcation.”An implication of Popper’s definition is that one can never becompletely sure that any scientific theory is true. Acceptedscientific theory is only theory that has not yet been contradictedby evidence, though the future may bring a contradiction. Forexample, we cannot be absolutely sure that the statement, “Thesun will rise in the east tomorrow” is true because it is ascientific statement. We can easily think of a logical possibilitythat would refute it—a sunrise in the west. We have greatconfidence that such an event will not happen because the sunhas always risen in the east. However, the fact that all previousexperience has been consistent with the statement does notprove that the statement will never be refuted.Popper saw the growth of scientific knowledge as a process ofconjecture and refutation. Someone originally comes up witha way of explaining a set of facts; a conjecture or guess or theoryabout how the facts are related. If further observation isinconsistent with the theory, the theory is considered refutedand a new theory or conjecture must be found. In contrast, ifthe original explanation is nonscientific, it will never be refutedand there will never be any need to change beliefs.Most economists see their discipline as scientific in Popper’ssense of the word. Economic theory makes statements abouthow facts fit together, and there are constantly new sets of factsarising that allow one to test the theory to see whether the factsare as theory predicts. However, this process is more difficult foreconomists than it is for physical scientists.Unlike physical scientists, economists can almost never usecontrolled experiments to gather facts with which to testtheories. Rather they must use whatever facts the world givesthem and rely on statistical procedures to draw conclusions.
Though statistical procedures let economists hold somevariables constant to see the effect of other variables, just as acontrolled experiment does, they are subject to serious limita-tions. If there are variables that the theory says are important,but they cannot be measured or they can be measured onlyimperfectly, statistical procedures may give misleading results.Or the procedures may fail if the theory is uncertain exactlywhich of the many possible variables that may be involvedmust be controlled. One strength of a properly done controlledexperiment is that there is no need to list all the factors that arecontrolled. The procedure is such that only one factor, or a smalland known group of factors, is different between the controland experimental groups. Given these difficulties, it is notsurprising that controversy about whether a theory is supportedor rejected by the facts can last for many years in economics.1
There is a minority of economists, however, who do not seeeconomics as scientific in Popper’s sense. A group of econo-mists called the Austrian school, for example, has argued thateconomics starts with assumptions and that economic theory isthe logically deduced results of those assumptions. If thetheory does not fit the facts, one cannot conclude that thetheory is wrong, but only that it is inappropriate to apply thetheory in that particular situation because the initial conditionsdo not agree with the assumptions of the theory.Besides distinguishing between scientific and nonscientificstatements, one can make a positive/normative distinction.
1.4 Positive and NormativeEconomists make a distinction between positive and normativethat closely parallels Popper’s line of demarcation, but which isfar older. David Hume explained it well in 1739, and Machiavelliused it two centuries earlier, in 1515. A positive statement is astatement about what is and that contains no indication ofapproval or disapproval. Notice that a positive statement can bewrong. “The moon is made of green cheese” is incorrect, but itis a positive statement because it is a statement about whatexists.A normative statement expresses a judgment about whether asituation is desirable or undesirable. “The world would be abetter place if the moon were made of green cheese” is anormative statement because it expresses a judgment aboutwhat ought to be. Notice that there is no way of disprovingthis statement. If you disagree with it, you have no sure way ofconvincing someone who believes the statement that he iswrong.Economists have found the positive-normative distinctionuseful because it helps people with very different views aboutwhat is desirable to communicate with each other. Libertariansand socialists, Christians and atheists may have very differentideas about what is desirable. When they disagree, they can tryto learn whether their disagreement stems from differentnormative views or from different positive views. If theirdisagreement is on normative grounds, they know that theirdisagreement lies outside the realm of economics, so economictheory and evidence will not bring them together. However, iftheir disagreement is on positive grounds, then furtherdiscussion, study, and testing may bring them closer together.
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Economists can confine themselves to positive statements, butfew are willing to do so because such confinement limits whatthey can say about issues of government policy. Both positiveand normative statements must be combined to make a policystatement. One must make a judgment about what goals aredesirable (the normative part), and decide on a way of attainingthose goals (the positive part). Economists often see cases inwhich people propose courses of action that will never get themto their intended results. If economists limit themselves toevaluating whether or not proposed actions will achieveintended results, they confine themselves to positive analysis.(You should realize that although economists can speak withspecial authority on positive issues, even the best can be wrong.)However, most economists prefer a wider role in policy analysis,and include normative judgments as well. On normative issueseconomists cannot speak with special expertise. Put somewhatdifferently, addressing most normative issues ultimatelydepends on how one answers the following question: “What isthe meaning of life?” One does not study economics to answerthis question.Most statements are not easily categorized as purely positive orpurely normative. Rather ,they are like tips of an iceberg, withmany invisible assumptions hiding below the surface. Suppose,for example, someone says, “The minimum wage is a bad law.”Behind that simple statement are assumptions about how tojudge whether a law is good or bad (or normative statements)and also beliefs about what the actual effects of the minimumwage law are (or positive statements).Next we discuss unintended consequences.
1.5 Unintended ConsequencesThe conventional definitions of economics ignore an importantaspect of the field. Economists are not interested in examiningevery case of actions based on costs and benefits, but only onthose that have some sort of unexpected or unintendedconsequences. Because we live in systems so complex that wecannot fully understand them, our choices can have system-wideimplications that we neither intended nor expected. Economicsstarts with individuals making choices based on self-interest,but it is primarily interested in how these actions affect society asa whole. Do these choices lead to chaotic results or to harmoni-ous ones?Their concern with unintended consequences of human choiceand action leads economists to argue that good results do notnecessarily come from good intentions, and that good inten-tions do not necessarily lead to good results. In contrast, partsof our popular culture believe that intentions determine results.For example, people who try to find a conspiracy behind all theworld’s problems, whether that conspiracy be of Communists,Jews, bankers, the CIA, or multinational oil companies, startwith a belief that bad results must come from bad people withbad intentions.As with any other field of study, economics has had a historyand there are books that attempt to trace the trail of economicthought back to its origins. Though the trail can be traced backto the ancient Greeks, it is a difficult trail to follow prior to1776. In 1776, Adam Smith published The Wealth of Nations, abook that was clearly about economics and that inspired a large
number of books, pamphlets, and articles in the next 50 years.Before this book most ideas about economics were scattered inwritings that were mostly about politics or ethics or philosophy,not in books that were clearly about economics. Yet if onelooks at the topics and theories that modern economicstextbooks contain and compares them to those things Smithdiscussed, one is struck by how little of contemporary econom-ics comes directly from Smith. What does come from Smith is aconcern about and an interest in unintended consequences.The most famous term in the Wealth of Nations is “invisiblehand.” Smith used this term only once, in the followingquotation:“...[B]y directing that industry in such a manner as its producemay be of the greatest value, he intends only his own gain, andhe is in this, as in many other cases, led by an invisible hand topromote an end which was no part of his intention. Nor is italways the worse for the society that it was not part of it.”Another quotation makes clearer what unintended conse-quences the invisible hand leads to:“Every individual is continually exerting himself to find out themost advantageous employment of whatever capital he cancommand. It is his own advantage, indeed, and not that of thesociety, which he has in view. But the study of his ownadvantage naturally, or rather necessarily leads him to prefer thatemployment which is most advantageous to society.”Smith was not sophisticated in the level of economic theorythat he used. He did not understand concepts that are consid-ered basic today, such as the model of supply and demand.(Alfred Marshall developed the modern treatment of supplyand demand a century after Smith.) In his comprehensivesurvey of economic theory, Joseph Schumpeter dismissesSmith as a theorist, saying,“The fact is that the Wealth of Nations does not contain a singleanalytic idea, principle, or method that was entirely new in1776.”Though the idea that there could be systematic unintendedconsequences was “in the air” at the end of the eighteenthcentury, no one articulated it as well as Smith did. Because heexpressed so well the idea that these unintended consequencesare of vital importance for understanding how a society works,Smith has often been called “the father of economics.” Hisbook is concerned with a question that has interested econo-mists for two hundred years: Under what conditions are actionsbased on self-interest beneficial to society? Much of economictheory has been developed and improved in an effort to getbetter answers to this question.The two most influential economists in the generation afterAdam Smith were David Ricardo and Thomas Malthus.Though they disagreed about many things, they were in generalagreement about the topic of population growth, and it was forhis writings on this topic that Malthus is best known. Malthusbelieved that there was a tendency for human populations togrow more rapidly than the food supply could be increased.Land was fixed in amount, and more food could be producedeither by tilling it more intensively or by adding less-productiveland to tillage. In either case an extra hour of labor brought less
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than an average return of food. The implication of these twodifferent growth rates is clear—eventually a segment of thepopulation would face starvation, and this would cut thegrowth rate of population.Malthus’ argument on population is pregnant with possibleunintended consequences. Suppose that society aids its mostneedy members by giving them food. As a result, they cansurvive and reproduce. Helping the poor would, according toMalthus’ argument, increase population and in the future leadto even larger numbers on the verge of starvation. Hence,charity would be self-defeating. All attempts to improve societyseem doomed to failure, according to a strict reading of theMalthusian argument, a truly “dismal” conclusion, as Carlylenoted.However, Malthus and Ricardo were wrong when they appliedthis argument to human populations. The predictions theymade did not occur. They underestimated both the capability oftechnology to improve crop yields and the future of birth rates.As it became apparent that they were wrong, economists losttheir interest in the study of population. It seemed not to havethe unintended consequences for them to explore. Since thattime, economists have occasionally developed other clevertheories with intriguing possibilities of unintended conse-quences, only to find that they too were in conflict withreal-world experience. The reader should bear this in mind as helearns what contemporary economists believe. There is apossibility that today’s secure truth may be tomorrow’sembarrassing mistake.Now some advice for you how to study of economics.
1.6 How to Study EconomicsAgatha Christie wrote a series of mystery novels in which shechallenged the reader to outwit her fictional heroine, Miss JaneMarple. By the end of the book, the reader has the same factsthat Miss Marple has. But the facts do not speak for themselves.Rather it is Miss Marple’s ability to look at those facts in a specialway, to see something significant where most readers seenothing, which lets her solve the mystery.Facts in economics, as in an Agatha Christie novel, need to beorganized in some way before they can tell one anything. Bythemselves they are meaningless. Thus, the study of economicsinvolves more than a memorization of facts. Economics triesto organize facts with its theory. Good theory tells us whichfacts are important and which are not, and what is cause andwhat is effect. The study of economics involves learninghow to organize facts the way economists do.People who do not understand economics still try to makesense of the world around them by trying to see pattern in thefacts they observe. Sometimes they use a simplistic “good-versus-bad” model. In a good-versus-bad model there are twoconflicting groups who are classified as good people and badpeople. These groups are usually involved in a zero-sum game:one person’s gain is another’s loss. Further, evil motives,possessed by the bad people, lead to bad results unless thesepeople are in some way controlled. Good motives lead to goodresults.
An example of a good-versus-bad viewpoint was expressed at atown meeting of a small Indiana community during the winterof 1977. The meeting focused on the natural-gas shortages thatthe community was facing. One citizen declared that the townfaced not an energy problem, but a pricing problem. He notedthat several years previously there had been shortages ofgasoline at 40 cents per gallon but no shortages at 60 cents.Therefore, he declared, there must have been a conspiracy at thattime by oil companies to increase prices as there was now by gasproducers. The events he observed do fit into a good-versus-bad framework. He saw a bad result. He saw a bad motive—thedesire for profit seems to many people the same as greed oravarice. To connect motive and result, he inferred the existenceof a conspiracy.Though a good-versus-bad model is sometimes appropriate(especially in small-group situations), economists are veryreluctant to use it. The economic model of supply and demandgives a more sophisticated interpretation of the gasolineshortage; one that is depersonalized and unemotional with nobad groups involved. This model suggests that, in cases ofshortages, one should search for government regulation ofprices. The good-versus-bad model does not suggest that suchregulation is something one should look for. In fact there wereprice restrictions in place at the time, and such restrictions canlead to shortages. The good-versus-bad view of the world isattractive because we are able to understand the model at a veryyoung age and because we see the model used so often: in fairytales, in comic books, in movies, and in television shows,among other places. Because we know how to use this model,and because our culture discourages use of alternative explana-tions such as fate or mystery, it is easy to fall back to this modelif we do not have a more sophisticated model to explain ourworld.Economic issues affect us all and most people have opinionsabout them. These opinions may be based on a good-versus-bad view, some other non-economic framework, or simplyslogans that are often repeated. Often the hardest problemstudents have in learning about how economists interpret theworld is to unlearn their old, non-economic views.Unlearning old ways of thinking can be difficult, as a well-known example illustrates. In the late 15th century ChristopherColumbus believed that by sailing a relatively short distance tothe West, he could reach Asia. Contrary to popular myth, it wasColumbus, not his critics, who had an outdated view of theworld. He believed that the world was much smaller and thatAsia was much larger than they actually are; his critics in theirguesses were much closer to the truth.Columbus made four trips to the Caribbean, but he neverrealized the significance of what he had found. He diedbelieving that he had found a short cut to the Far East. Ratherthan use the facts he had before him to alter and improve hisideas of world geography, he insisted on keeping his old viewsand trying to make the facts fit in.Economic education involves learning to see reality from newperspectives. Sometimes these new perspectives may surpriseyou. They may even shock you. But if you take the time to lookat the reasoning behind these economic ways of looking at
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things, you will find that they consist of carefully-thought-out-and-applied common sense.To summarize the lesson I can say that the Economics isessentially a subject that looks at choices - how individuals,governments and businesses make them and what the conse-quences of making those decisions are. It is likely to be a stronglikelihood that every issue raised in the class involves someform of decision or choice - for example, if fines were theanswer to poor attendance - the choice being to remain absentand get fined or to attend the class and avoid the fine - thequestion may then be how much of a fine is necessary beforethose who choose to remain absent feel the cost of doing so istoo great? All this can be precisely summarized through thefollowing figure :
Figure 1.1 The Economic Problem
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Lesson 2 attempts to further your understanding of whateconomics is by delving more deeply into the concept of scarcityand introducing the most important notions of economics:opportunity cost and economic efficiency. As you will see, theseconcepts are fundamentally involved with the problem of howbest to allocate scarce resources
2.1 ScarcityEconomics is the study of how economic agents or societieschoose to use scarce productive resources that have alternative usesto satisfy wants which are unlimited and of varying degrees ofimportance. The main concern of economics is economicproblem: its identification, description, explanation andsolution, if possible. The source of any economic problem isscarcity. Scarcity of resources forces economic agents to chooseamong alternatives. Therefore economic problem can besaid to be a problem of choice and valuation of alterna-tives. The problem of choice arises because limited resourceswith alternative uses are to be utilized to satisfy unlimitedwants, which are of varying degrees of importance. Had theresources like human, natural, capital, etc. not been scarce, therewould have been no problem of choice and hence no economicproblem at all. Therefore, the root cause of all economicproblems is scarcity.In another words you can say that Scarcity means that youwant more than is available. Scarcity limits us both as individu-als and as a society. As individuals, your limited income (andtime and ability) keep you off from doing and having all thatyou might like. As a society, limited resources (such as man-power, machinery, and natural resources) fix a maximum on theamount of goods and services that can be produced for you.Scarcity is a central concept in economics. Resources scarcity isdefined as there being a difference between the desire and thedemand for a good. This means that the collective desire ofindividuals for goods and services exceeds the productiveresources (natural, human, and capital) available to satisfythose desires. What this means is that a good is scarce if peoplewould consume more of it if it were free. In other words, thethings of value that people want are virtually unlimited, whilethe productive resources necessary to produce these things arelimited. Every society, rich or poor, must determine how to bestuse its scarce productive resources to produce goods andservices. This is the basic economic problem.Table 2.1 Following could be an suggestive list of DesiredGoods & Limited Resources :
Economic Goods (wants) Limited Resources (scarcity) Food Land Clothing Cotton & other resources National Defense Human Resource Education No. of institutes, fee you can afford…..
Let us take an example, you may want to own gold jewelery.However, the amount of gold available is limited, so it is
LESSON 2:SCARCITY, CHOICE AND EFFICIENCY
necessary to make choices as to how it is allocated. In a marketeconomy, this is achieved by trade. Individuals trade resourcesbetween themselves to reallocate resources to where they aremost wanted. In a smoothly operating market system, the rateof exchange between different resources, or price will adjust sothat demand is equal to supply. One of the roles of theeconomist is to discover the relationship between demand andsupply and develop mechanisms (such as pricing, incentives, orpenalties) to achieve an optimal outcome (in terms of con-sumer welfare) between supply and demand.Scarcity is a relative concept. It can be defined as excess demandi.e. demand more than the supply. For example. unemploy-ment is essentially the scarcity of jobs. Inflation IS essentiallyscarcity of goods.Another concept which you need to understand is ofCHOICE.
2.2 ChoiceBecause goods and services are scarce, choices must be made.Scarcity - the available resources are insufficient to satisfypeople’s wants - is universal. All individuals, households,business firms, communities, nations - rich and poor alike -confront scarcity. The fundamental economic problem is theappropriate use of limited resources to produce the goods andservices that we value most. Economics, therefore, can bedefined as the study of the choices people make in order tocope with scarcity. Economists study (among other things) howsocieties perform the optimal allocation of these resources.Scarcity requires choice. People must choose which of theirdesires they will satisfy and which they will leave unsatisfied.When we, either as individuals or as a society, choose more ofsomething, scarcity forces us to take less of something else.Economics is sometimes called the study of scarcity becauseeconomic activity would not exist if scarcity did not force peopleto make choices.The resources (also called inputs or factors of production) thatcan be used to produce goods and services are divided into fourmain categories:• Land, the gifts of nature such as air, water, land surface and
minerals lying beneath the earth’s surface.• Labor, the time and physical or mental effort devoted to
producing goods and services.• Capital, goods made by people that are used to produce
other goods and services (factories, tractors, buildings, powerplants, hand or power tools, machinery, equipment,transportation networks, etc). Human capital is theknowledge and skill people possess from education andvocational training. You are building human capital rightnow as you work towards your degree.
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• Enterpreneurial ability, the resource that organizes land,labor and capital. The enterpreneur is the person who sets upa firm by combining all factors of production in order toproduce a good or service. While labor receives wages orsalaries for the work, the enterpreneur expects to receiveprofits for his efforts.
With the scarcity and choice in comes the COST FACTOR.Next what you need to understand is the concept of Cost.
2.3 Concept of costTill now you must be aware of that the root cause of economicproblems is scarcity. Therefore, you need to be careful aboututilization of each and every unit of scarce resources. To decidewhether to use an additional unit of resource you need to knowthe additional output expected there from. Economists use theterm marginal for such additional magnitude of output.Therefore marginal output of labor is the output produced bythe last unit of labor, marginal revenue is the additionalrevenue generated by an additional unit sold and marginalcost of production is the cost incurred for producing anadditional unit of output. While using the marginal conceptwe should be careful of the nature of relationship between thevariables. In the above situations labor, sales and outputproduced are independent variables and output, revenue andcost are dependent variables respectively. In the same way ifsales depend on advertisement, you talk of ‘marginal sales ofadvertisement’; but if advertisement depends on the salesrevenue, then you talk of ‘marginal advertisement of sales’ .The concept of marginalism assumes that the independentvariable changes by a single unit. In practice the independentvariable may be subjected to “chunk changes” rather than unitchanges. A contractor working on a turnkey project may changethe labor employed not by one, but by tens and hundreds.Similarly, the costs and benefits of computerization are notsubject to marginal analysis. In such situations the concept ofincrementalism is more useful. In the above situations we talkabout incremental output of labor and incremental costs andbenefits of computerization respectively. In fact, incrementalismis more general whereas marginalism is more specific. Allmarginal concepts are incremental concepts; but all incrementalconcepts need not be confined to marginal concepts aloneThe cost of any choice is the option or options that a persongives up. For example, if you gave up the option of playing acomputer game to read this text, the cost of reading this text isthe enjoyment you would have received playing the game. Mostof economics is based on the simple idea that people makechoices by comparing the benefits of option A with the benefitsof option B (and all other options that are available) andchoosing the one with the highest benefit. Alternatively, one canview the cost of choosing option A as the sacrifice involved inrejecting option B, and then say that one chooses option Awhen the benefits of A outweigh the costs of choosing A(which are the benefits one loses when one rejects option B).The true cost of anything that is scarce is its opportunity cost,what is given up to get it. In other words, the opportunity costof an action is the highest valued alternative forgone.
Now when you know the concept of Opportunity Cost withrespect to an individual. I will go ahead with the concept withreference to a firm and then with the entire society.
2.3.1 Scarcity and Choice for a Single FirmThe production possibilities frontier (PPF) shows thedifferent combinations of various goods that can be producedgiven the available resources and existing technology. The PPFmarks the boundary between combinations of goods andservices that can be produced and combinations that cannot.Different resources are not equally effective in producingdifferent goods. Thus, along the PPF, producing more of onegood has increasing opportunity costs. Most activities in thereal world are subject to increasing opportunity costs.The opportunity cost of an action is the highest valuedalternative forgone. On the PPF, the the opportunity cost ofproducing more of one good (e.g., soyabeans) is the output ofthe other good that must be forgone (e.g., wheat). Theopportunity cost of a bushel of soyabeans is the number ofbushels of wheat that must be forgone per bushel ofsoyabeans; therefore, opportunity cost is a ratio. The opportu-nity cost of a bushel of wheat is the inverse of the opportunitycost of a bushel of soyabeans. The following table shows theopportunity cost of producing wheat in the place of soybeanand vice versa.Table 2.2 - Calculation of the opportunity cost
OPPORTUNITY COST OF:
POINT SOYABEANS WHEAT SOYABEANS WHEAT
1 40 0 (38 - 0 / 40 - 30) = 38/10 -
2 30 38 (52 - 38 / 30 -20) = 14/10
(40 - 30 / 38 - 0) = 10/38
3 20 52 (60 - 52 / 20 -10) = 12/10
(30 - 20 / 52 - 38) = 10/14
4 1 0 60 (65 - 60 / 10 - 0) = 5/10
(20 - 10 / 60 - 52) = 10/12
5 0 65 - (10 - 0 / 65 - 60) = 10/5
2.3.2 Scarcity and Choice for the Entire SocietyEconomic growth is the expansion in production. Two factorscause economic growth:• Technological progress is the development of new goods
and services and better ways to produce goods and services• Capital accumulation refers to the growth in a society’s capital
resources.The greater the rate of capital accumulation and/or technologi-cal process, the more rapidly the PPF expands, that is, the morerapid is economic growth. Economic growth is costly. Theopportunity cost is incurred because resources are devoted tomanufacturing capital goods and developing new technologiesrather than to producing goods for current consumption.Nations that incur the cost of devoting more of their resourcesto capital accumulation or technological change grow morerapidly than nations that choose not to pay the cost and thusdevote fewer resources to such purposes.Form this discussion you must have got an idea that success ofan individual, or a firm, or the entire nation depends on the
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Effective utilization of the resources. Now I will take up theconcept of Efficiency.
2.4 The Concept of EfficiencyEfficiency is a relative term. It is vital that this point be under-stood. Efficiency is never absolute; it is always relative to somecriterion. This can be seen when one asks if farms are moreefficient in the United States or China. The farming techniquesin China are more efficient than those in the United States whenmeasured in terms of output per unit of land, output per unitof fossil fuel, or output per unit of machinery. The farms in theUnited States are far more efficient in terms of output per man-hour. The statement that farms in one country are moreefficient than farms in another makes no sense unless thecriterion on which efficiency is measured is given. In otherwords I can say that “Efficiency is the relationship between whatan organization or an economy produces & what it couldfeasibly produce”.The criterion for economic efficiency is value. A change thatincreases value is an efficient change and any change thatdecreases value is an inefficient change. A situation that iseconomically efficient may be inefficient when judged ondifferent criteria. An example may make this concept clear.Value is subjective. A thing has value only if someone wantsit. How then can we know if value is maximized? If there issome change that makes someone feel better off, but makingthis change does not make anyone feel worse off, then theoriginal situation was not one of highest value. Improvementwas possible. When the highest value is reached, then anypossible change that helps anyone must harm someone else.This way of defining economic efficiency, Pareto optimality, isnamed after Vilfredo Pareto, an early mathematical economist.Economists are interested in economic efficiency for tworeasons, one positive and the other normative. The positivereason is based on the observation that people search for value.We see this search for value vividly illustrated in the occupationsof pimp, drug pusher, and hit man; given enough money, anyoccupation, no matter how immoral or risky, will attract people.On the theoretical level, we have seen this search for value indiscussing utility maximization and profit maximization. Thesearch for value is the driving force of market (and perhapsmost nonmarket) economies. If there are situations in whichthere is unexploited value, that is, value that is possible butwhich no one obtains, the economist needs to explain whysomeone does not find a way to capture this value.The normative reason stems from a desire to make policyrecommendations. It is possible to discuss some aspects ofpolicy without normative assumptions. An economist canpredict, for example, whether a policy will or will not achieve thegoals set for it. But economists often want to do more. Theyoften want to compare two policies or two situations anddecide which is better. To decide which is better requires somesort of basis for ranking situations. Thus, if they want to askwhether government regulation of utility prices, a tariff onsteel, or a program to train unskilled workers helps society,economists need a criterion on which to base their answer.Economists generally use the criterion of economic efficiency toevaluate situations, though they often supplement it with other
considerations because economic efficiency is not the only wayto judge the relative merits of two situations.The value maximized in the notion of economic efficiencyreflects the goals people have. The concept of economicefficiency treats all goals as equally valid; no goals are consideredbetter than other goals (with one exception—envy—discussedin the following paragraph). Not everyone agrees. Judging goalshas been a central feature of the Judeo-Christian tradition.Generally, this tradition has condemned as immoral goal-seeking that emphasizes the most narrow individualism such ashedonism. To be moral, people must take into considerationthe well-being of some others as a goal, including family or clanmembers and others who are members of a communitygrouping.Production efficiency means that more of one good cannotbe produced without decreasing the production of anothergood. Production efficiency occurs only when production takesplace on the frontier line. Because another good must be givenup, there is a tradeoff. If you are at a point 1 on table 1.2,production is inefficient because there are unused ormisallocated resources.Resources are unused when they lie idle but could be working.For example, you can leave some of the land used for thecultivation of soyabeans idle or some workers might beunemployed. Resources are misallocated when they areassigned to tasks for which they are not suitable. For example,you can assign land best suited to soyabean cultivation to wheatcultivation, or assign skilled soyabean workers to work in wheatcultivation. But yau can get more soyabeans and more wheatfrom the same inputs (i.e., land and/or labor) if we reassignedthem to tasks that closely match their skills.If you produce at a point 2, 3 or 4, you can use your resourcesmore efficiently to produce more soyabeans and more wheat ormore of both soyabeans and wheat.From this I can very easily say that any individual, or organiza-tion, or an economy should know the answer to the five bigquestions, discussed below:
2.5 The Five Big Questions
Every society must figure out what is referred in economics asthe “how”, “what”, “when”, “where” and “for whom” toproduce:1. How to produce or How to utilize its resources
efficiently - it is the choice among different resourcecombinations and techniques used in the production of agood or service. A good or service can be produced withdifferent resource combinations and techniques; the problemis which of these to use. Since resources are limited, when agreater quantity is used to produce a particular good orservice, less quantity is available for the production ofanother good or service. The problem facing society ischoosing the right resource combination and productiontechnique so that the cost in terms of the resources used foreach unit of the good or service it decides to produce will beminimal. “How to produce”: Because the price of a resourcereflects its relative scarcity, the best way to produce a good orservice is to ensure the least money cost of production. If
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the price of a resource rises relative to the price of othersused in the production of the particular good or service,producers will switch to another production technique: theone that uses less of the more expensive resource. Theopposite holds true when the price of resource falls relativeto the price of others.
2. What to produce or What combination of goods andservices to produce - Since resources are scarce, no economycan produce as much of every good or service as desired byeveryone. More of a good or service means less of others.So, society must choose which goods and services to produceand in what quantities. “What to produce”: the pricemechanism ensures that only those goods and services forwhich consumers are willing to pay a price sufficiently high tocover at least the full cost of production will be supplied byproducers. A higher price induces producers to increase thequantity supplied of a good. Alternatively, a fall in price willinduce producers to decrease the quantity supplied of agood.
3. For whom to produce : The economy will produce thosegoods and services that satisfy the wants of thoseconsumers who can afford them. The higher the income ofconsumers, the more the economy will be geared to producethose goods and services they want and are willing to pay forthem. “How much of each good to distribute to eachperson” - The problem of how to divide up what has beenproduced among the consumers, that is, how many of theconsumers’ wants can be satisfied. Scarcity ensures thatsociety cannot satisfy the wants of all its members.
4. When to produce : The economy will produce the goodsand services when they are needed most. So that they earnmaximum profit.
5. Where to produce : This relates to the decision regardingthe place of production to yield maximum profit. Eg, if youproduce nearer to the raw material then the cast of inputswill be less, but you produce nearer to the market the cast oftransportation of output will be less.
All individuals, organizations and nations can produce all thegoods and services required by them, but the point is who canproduce it with minimum inputs and maximum outputs. Thisis where the specialization starts. Now let me tell you aboutspecialization and the cooperative advantage achieved throughspecialization.
2.5.1 Specialization & Comparative AdvantagePeople, businesses and nations can produce for themselves allthe goods and services they consume, or they can concentrate onproducing one good or service (or, possibly, a few goods orservices) and then trade with others, that is, exchange some oftheir own goods or services for those of others. Specializationis the concentration on the production of only one good orservice, or a few goods or services.The principle of comparative advantage states that eachnation (or individual) should specialize in the production ofthe good or service in which he is more efficient (or lessinefficient). Stated differently, an individual or a nation has acomparative advantage in producing something if he can
produce it at a lower opportunity cost than anyone else. Thisstems from the fact that people’s abilities differ and, as a result,different people have different opportunity costs of producinga particular good or service.It should be noted that it is not possible for anyone to have acomparative advantage in everything. Thus, gains from special-ization and trade are always available when opportunity costs aredifferent. Specialization requires a system of exchange to enjoythe fruits of comparative advantage. A voluntary exchange mustyield mutual gains, that is, to make both parties better off.This concept of exchange is the mother of markets. Now youwill have a look on how market and prices work and how theyare coordinated to get maximum comparative advantage.
2.5.2 Markets, Prices and the Coordination TasksMarkets bring together buyers and sellers of goods and services.A market is any arrangement that enables buyers and sellers toget information and to do business with each other. Prices ofgoods and of resources, such as labor, machinery and land,adjust to ensure that scarce resources are used to produce thosegoods and services that society demands.Much of economics is devoted to the study of how marketsand prices enable society to solve the problems of how, what,when, where and for whom to produce, and this is thecoordinate task to find the optimum mix of the following:1. What ?2. When ?3. Where ?4. How ?5. For Whom ?The widespread use of definitions emphasizing choice andscarcity shows that economists believe that these definitionsfocus on a central and basic part of the subject. This emphasison choice represents a relatively recent insight into whateconomics is all about; the notion of choice is not stressed inolder definitions of economics. Sometimes, this insight yieldsrather clever definitions, as in James Buchanan’s observationthat an economist is one who disagrees with the statement thatwhatever is worth doing is worth doing well. What Buchanan isnoting is that time is scarce because it is limited and there aremany things one can do with one’s time. If one wants to do allthings well, one must devote considerable time to each, andthus must sacrifice other things one could do. Sometimes, it iswise to choose to do some things poorly so that one has moretime for other things.
2.6 Introduction to Production Possibility FrontiersI am sure that by now you know that scarcity necessitateschoice. More of one thing means less of something else. Theopportunity cost of using scarce resources for one thinginstead of something else is often represented in graphicalform as a production possibilities frontier. The opportunitycost of producing (or Consuming) one good is how much ofthe alternative good must be sacrificed. Similarly, the per-unitopportunity cost tells us how much of a good is sacrificed inorder to gain one additional unit of an Alternative good.
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In other words, If a firm can produce two or more outputs orcan produce output in two or more periods, a productionpossibility frontier can describe the possible combinations ofoutput that can be attained for a given set of inputs.Now you can very comfortably say that, the ProductionPossibilities Frontier (PPF) is a graphical representationwhich shows the maximal combinations of two goods that canbe produced during a specific time period given fixed resourcesand technology and making full and efficiency use of availablefactor resources. A PPF is normally drawn as concave to theorigin because the extra output resulting from allocating moreresources to one particular good may fall. This is known as thelaw of diminishing returns and can occur because factorresources are not perfectly mobile between different uses, forexample, re-allocating capital and labour resources from oneindustry to another may require re-training, added to a cost interms of time and also the financial cost of moving resourcesto their new use. This cost, you know is called as, opportunitycost. The formula for calculating Per Unit Opportunity Cost(PUOC) is as :
Scarcity is the basis of many economic concepts because itconstrains or limits our behavior. Let us explore the notion ofconstrained behavior by starting with the simplest sort ofeconomic structure, suppose that YOU are alone on an island.Now each day YOU have enough time to produce 15 thousandbottles of wine or 15 thousand bushes of grain. Notice thatYOU cannot have both i.e., wine and grain. If YOU use yourtime to produce wine, you do not have that time to producegrain. If you want both wine and grain, you can devote sometime to both. If, for example, you spend half of the dayproducing wine and the other half for producing grain, you canhave 7500 bottles of wine and 7500 bushes of grain.Table 2.3 Production Possibility Table
Wine (thousands of bottles)
Grain (thousands of bushels)
0 15 5 14 9 12 12 9 14 5 15 0
A list of all the possible combinations of wine and grain opento YOU makes up your production possibilities. Theproduction-possibilities frontier separates outcomes that arepossible for an individual (or a group) to produce from thosewhich cannot be produced. Because YOU cannot exchange, your
production-possibilities frontier is also your consumption-possibilities frontier . The consumption-possibilities frontier(sometimes called the budget constraint) is the line indicatingwhich outcomes are affordable and which are not affordable.The graph below illustrates your production-possibilitiesfrontier (and his consumption-possibilities frontier). Be sureyou understand that the information in the table above isexactly the same as the information in the graph below—theseare two different ways of presenting that information.Figure 2.1 Production Possibility Frontier
The slope of the frontier in the graph above measures the costsyou are facing. In order to get extra wine, YOU must sacrificesome grain, and vice versa. Notice that there is no moneyinvolved; cost does not depend on money, but rather existswhenever there is scarcity and choice. In economics, the cost ofanything refers to whatever is given up in order to get thatthing. The cost of going to college, for example, includes notonly the money a person spends on tuition (which could bespent on something else), but also includes the time spentstudying and going to classes. The value of this time can beestimated by computing the amount of income a person couldearn if he did not go to college.An example of a conventional PPF is shown in the diagramabove which shows potential output of Wine and Grains froma given stock of labour and capital. Combinations of the twogoods that lie within the PPF are feasible but point ‘a’ show anoutput that under-utilizes existing resources or where resourcesare being used inefficiently. Combinations of the two goodsthat lie on the PPF are feasible and can be produced using allavailable factor inputs efficiently. In the PPF diagram above, thecombination of output shown by point ‘b’ is unattainablegiven current resources and the productivity of the availablefactor inputs. The PPF shows all efficient combinations ofoutput for this island economy when the factors of productionare used to their full potential. The economy could choose tooperate at less than capacity somewhere inside the curve, forexample at point a, but such a combination of goods would beless than what the economy is capable of producing. A combi-nation outside the curve such as point b is not possible sincethe output level would exceed the capacity of the economy. Theshape of this production possibility frontier illustrates theprinciple of increasing cost. As more of one product is
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produced, increasingly larger amounts of the other productmust be given up. In this example, some factors of productionare suited to producing both wine and grain, but as theproduction of one of these commodities increases, resourcesbetter suited to production of the other must be diverted.Experienced wine producers are not necessarily efficient grainproducers, and grain producers are not necessarily efficient wineproducers, so the opportunity cost increases as one movestoward either extreme on the curve of production possibilities.If you reflect on this table, you will see the importance ofscarcity. You can think of the production-possibilities frontier asthe way economists visualize scarcity. Which of the options willYOU choose? I cannot tell because I can only compute costsfrom this information, not benefits. The favorite assumptionof economists is that individuals base their actions on the costsand benefits that they see. Benefits depend on the goals YOUhave, and the production-possibilities frontier has no informa-tion about them
2.6.1 Shift in the PPFThe production possibility frontier will shift when:a. There are improvements in productivity and efficiency
(perhaps because of the introduction of new technology oradvances in the techniques of production).
b. More factor resources are exploited (perhaps due to anincrease in the available workforce or a rise in the amount ofcapital equipment available for businesses to use).
In our example illustrated in the second diagram 2.2 below wesee the effects of a change in the state of technology thatallowed the wine producers to double their output for a givenlevel of resources. Further suppose that this technique couldnot be applied to grain production, i.e., resources allocated tograins are same as above. The real cost of WINE will fall – therehas been a change in the opportunity cost The impact on theproduction possibilities is shown in the following diagram:Figure 2.2 Shifted Production Possibility Frontier
In the above diagram, the new technique results in wineproduction that is double its previous level for any level ofgrain production. Finally, if the two products are very similar toone another, the production possibility frontier may be shapedmore like a straight line. Consider the situation in which onlywine is produced. Let’s assume that two brands of wine areproduced, Brand A and Brand B, and that these two brands usethe same grapes and production process, differing only in thename on the label. The same factors of production can produce
either product (brand) equally efficiently. The productionpossibility frontier then would appear as follows:Figure 2.3 Production Possibility Frontier for Very SimilarProduct
Note that to increase production of Brand A from 0 to 3000bottles, the production of Brand B must be decreased by 3000bottles. This opportunity cost remains the same even at theother extreme, where increasing the production of Brand Afrom 12,000 to 15,000 bottles still requires that of Brand B tobe decreased by 3000 bottles. Because the two products arealmost identical in this case and can be produced equallyefficiently using the same resources, the opportunity cost ofproducing one over the other remains constant between thetwo extremes of production possibilities.
2.7 The PPF and Economic EfficiencyAn efficient production point represents the maximumcombination of outputs given resources and technology –clearly the PPF is a useful way of illustrating this idea. Theeconomy efficiency can be classified into following :
2.7.1 Allocative EfficiencyAn economy achieves allocative efficiency if it manages toproduce the combination of goods and services that peopleactually want. For allocative efficiency to be achieved we need tobe on the PPF - because at points which lie within the frontier,it is possible to raise output of both goods and improve totaleconomic welfare. The definition of Pareto Efficiency is anallocation of output where it is impossible to make one groupof consumers better off without making another group at leastas worse off.
2.7.2 Productive EfficiencyProductive efficiency is defined as the absence of waste in theproduction process. When the production of the two goodslies on the frontier, anywhere on the frontier is deemed to beproduction efficient and production inside frontier is inefficient.Productive efficiency requires minimizing the opportunity costfor a given value of output. When there is an outward shift ofthe PPF perhaps due to improvements in productivity oradvances in the state of technology, then the opportunity costof production falls and society can now produce more fromgiven resources.
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2.7.3 Distributive EfficiencyWe achieve distributive efficiency if we get the goods andservices produced to those who actually want or need them.Where we are on the production possibility frontier has littlereal bearing on distributive efficiency, we tend to use the conceptto make comment on allocative and productive efficiency. Butwhen an economy achieves economic growth leading to anoutward shift in the PPF, economists have concerns over thedistribution of gains in output and whether or not an im-provement in average living standards has benefited themajority of consumers or whether there has been an increase ininequality and relative poverty.
2.8 Comparative AdvantageComparative Advantage addresses a situation where twoindividuals or (in this case) countries are able to benefit fromspecialization and trade. Below, we work through an exampleinvolving two countries, Country A and Country X, where eachcountry (first) attempts to meet domestic demand by producingonly what is needed, and then (second) follows the Law ofComparative Advantage.Country A produces compact cars and luxury cars and is able toachieve the following production possibilities (below). Thetable is written to reflect 10 different production/consumptionchoices (written as column/choice A through column/choice J).
A B C D E F G H I J
Compact cars 0 2 4 6 8 10 12 14 16 18
Luxury cars 9 8 7 6 5 4 3 2 1 0
To meet domestic demand, Country A must produce at pt. E(i.e. column E). Moving from pt. E to pt. D, Country A wouldhave to give up producing 2 compact cars in order to produce 1more luxury car. Because this country is fully employed, the onlyway to get more luxury cars is by taking workers out of compactcar production and putting them into luxury car production.Doing this between pts. D and E causes 2 less compacts to bebuilt. Therefore, the opportunity cost of that additional luxurycar is 2 compact cars.Moving from pt. E to pt. F, Country A must give up producing1 luxury car in order to produce 2 more compact cars. Therefore,the opportunity cost of each (1) additional compact car is ½ ofa luxury car.If we consider any other pair of points, we find that theopportunity is always the same (for each good) no matter wherewe start. This implies constant opportunity costs, and tells usthat the PPC here is a straight line.Country X produces compacts and luxury cars as well. TheirPPC relationship is:
Q R S T U V W X Y Z
Compact cars 0 1 2 3 4 5 6 7 8 9
Luxury cars 18 16 14 12 10 8 6 4 2 0
To meet domestic demand in Country X, it is necessary toproduce at pt. W. If we were to illustrate Country A and X’sproduction possibilities on a graph, then we would get thefollowing.
Calculating the opportunity cost here, as we did above, we get:Opportunity cost of each (1) additional compact car = 2 luxurycarsOpportunity cost of each (1) additional luxury car = 1/2 of acompact carNow, let’s compare the opportunity costs between countriesfor luxury cars:(A) Opp cost of each 1 luxury car = 2 compact cars(X) Opp cost of each 1 luxury car = 1/2 of a compact carfor compact cars:(A) Opp cost of each 1 compact car = 1/2 of a luxury car(X) Opp cost of each 1 compact car = 2 luxury carsCountry X gives up fewer compact cars when producing anadditional luxury car, while Country A gives up fewer luxury carswhen producing an additional compact car. Therefore, theopportunity cost of producing compacts is lowest in CountryX, and the opportunity cost of producing luxury cars is lowestin Country A.When Country A has a lower opportunity cost associated withproducing something, then A is said to have a comparativeadvantage in producing that item. Therefore, A has a compara-tive advantage in producing compacts, while X has acomparative advantage in producing luxury cars.The Law of Comparative Advantage says the following, “Byspecializing in the production of a good where a first countryhas a comparative advantage, the first country can trade withanother country (who specializes in something that the firstcountry doesn’t have a comparative advantage in) and become“better off”.Suppose Countries A and X specialize where they have com-parative advantage. Country A switches from pt. E to pt. J,while X switches from pt. W to pt. Q. We see this on thefollowing table:
Country A Domestic Demand
Specialize Country X Domestic Demand
Specialize
Compacts 8 18 Compacts 6 0
Luxury cars 5 0 Luxury cars 6 18
Country A now has 10 more compacts than needed domesti-cally, whereas X has 12 more luxury cars than neededdomestically. Assume that these countries are willing to trade ona 1-for-1 basis, and that A sends 9 compacts to X, in exchangefor 9 luxury cars. That gives us the following result:
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Country A
Before Trade
After Trade Country X Before
Trade After Trade
Compacts 8 9 Compacts 6 9
Luxury cars 5 9 Luxury cars 6 9
Do these countries benefit from specialization and trade? Yes,both have more of each good after trade than before trade. Byspecializing and trading, these countries can “consume”compact cars and luxury cars in amounts that would not bepossible if these countries tried to meet domestic demandalone. That is, these countries are able to consume outside theirPPC, even though they can’t produce outside of it. This isillustrated in the graph below.
Country A’s PPC and Country X’s PPC are combined on thesame graph. Consumption occurs at pt. M, a point that liesalong the (green) dotted consumption possibilities line. Pt. Mexists outside of each country’s ability to produce, but by usingthe Law of Comparative Advantage, doesn’t exist outside ofeach country’s ability to consume.Following are some important concepts of economics whichyou came across in this chapter :1. Opportunity Cost The idea is that anything you must give
up in order to carry out a particular decision is a cost of thatdecision. This concept is applied again and again throughoutmodern economics. If (God forbid) you were to learn onlyone of the Principles of Economics thoroughly, this shouldbe the one.
2. Scarcity According to modern economics, scarcity existswhenever there is an opportunity cost, that is, where-ever ameaningful choice has to be made.
3. Production Possibility Frontier The productionpossibility frontier is the diagrammatic representation ofscarcity in production.
4. Comparative Advantage A very important principle initself, and a key to understanding of international trade theprinciple of comparative advantage is at the same time anapplication of the opportunity cost principle to trade.
5. Discounting of Investment Returns Another applicationof the opportunity cost principle that is very important initself, this one tells us how to handle opportunities thatcome at different times.
In this lesson you have gone through:• Scarcity and Efficiency : the Twin themes of economics
• Opportunity Cost
• Science of Choice• The five big questions that economists seek to answer.
• What?• Why?• When?• Where?• For Whom?
• The Production-Possibility Frontiers
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1. Multiple Choice Questions1. From the viewpoint of economics, your college education
can be thought of as an investment in a factor ofproduction. Which factor is most appropriate?i. natural resourcesii. laboriii. physical capitaliv. human capitalv. entrepreneurship
2. A Production Possibilities Curve (PPC) illustrates theconcept of scarcity. Which item will be most likely to result ina shift of the PPC outward, indicating the ability to producemore goods?i. an increase in populationii. a decrease in the price of steeliii. reducing the federal debtiv. signing a trade agreement with Chinav. making more consumption goods
3. Which of the following questions is outside the scope ofeconomics?i. What is the likely impact of the transfer of Hong Kong
back to the Chinese?ii. When a paper mill closes in a small southern town, who
is most likely to be out of work for a long time?iii. When you graduate from college, how might you best
go about choosing a job?iv. How should society balance the needs of the
environment against the needs of industry?v. None of the above; all are within the scope of economic
study.4. The study of economics is generally divided into two majorsub-divisions: macroeconomics and microeconomics. Whichstatement is correct about the division?
i. Macroeconomics deals with unemployment, inflation,the budget deficit, and the trade deficit.
ii. Macroeconomics deals only with individual markets.iii. All the topics in macroeconomics are bigger than those
in microeconomics.iv. Microeconomics is limited to the study of individual
choices while macroeconomics deals with groupdecisions.
v. Only macroeconomics deals with prices.5. Which of the following is not a way we can use the study of
macroeconomics?i. to understand how a national economy works
TUTORIAL 1
ii. to understand the grand debates over economic policyiii. to decide between two types of automobiles when we
are buying a new cariv. to make informed business decisionsv. to help decide which candidate for office is most likely
to have a successful economic policy6. Which of the following is not a way we can use the study of
microeconomics?i. to understand how markets workii. to understand the full impact of our trade deficit with
Japaniii. to make personal or managerial decisionsiv. to evaluate the merits of specific public policiesv. to help decide between two automobiles when we are
buying a new car7. The process of “thinking like an economist” involves three
basic items. Which of the following five does not belong?• Economists use assumptions to simplify matters.• Economists deal only in items which have prices.• Economists explore the relaltionship between two
variables, holding other variables fixed.• Economists think in marginal terms.• Economists consider opportunity costs.
8. If a society is operating on its Production Possibilities Curve(PPC)with respect to thousands of computers and numbersof space missions, and is producing 300,000 computers and5 space missions, in order to increase the number of spacemissions it must• give up some computers.• produce more computers as well.• pay scientists more.• shift federal spending from military to science.• develop a new type of rocket.
9. The problem of scarcity,• exists only in market economies.• could be eliminated if we could force prices to fall.• means that there are shortages of some goods.• exists because human wants exceed available resources.• can be eliminated by government intervention
10.If Josiah is producing inside his Production PossibilitiesCurve (PPC) then he• can increase production of goods with no increase in
resources.• is fully using his resources.• is optimizing.
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• is unaffected by costs and technology.• can do no better than he is currently doing.
11. The following table gives production possibilities for aneconomy that can produce two goods: lobsters and boats.Graph the production possibilties curve (PPC), given theinformation in Table 1-1, and putting lobsters on thehorizontal axis. Use your graph to answer the first fourquestions. As this economy produces more and morelobsters, the slope of the PPC:
Table 1-1Lobsters Boats
A 0 10B 100 9C 200 7D 300 4E 400 0
• increases.• is constant.• decreases.• cannot be determined.
12.If the economy is producing at point C:• we can produce more lobsters and more boats.• we cannot produce any more lobsters.• we cannot produce any more boats.• we can produce more lobsters only by giving up some
boats.• the economy is not efficient.
13.At point B, to get one more boat, this economy must:• give up one lobster.• give up nine lobsters.• give up 100 lobsters.• increase the economy’s resources.• discover a new technology.
14.If this economy is producing 50 lobsters and 8 boats, then:• the economy could produce more lobsters without giving
up any boats.• the economy could produce more boats without giving
up any lobsters.• the economy could produce more boats and more
lobsters.• the economy is not operating efficiently.• all of the above
15.Economics is the study of:• stock markets.• money.• self-interest.• scarcity.• all of the above
16.Which of the following is NOT an example of a marginaldecision?
• Is it worth $2 to buy this extra slice of pizza?• If I study for one more hour, how much will it raise my
grade?• If I hire ten workers to produce tables, what will be the
average cost per table?• If I drive slightly faster, what will be the change in my
gasoline comsumption?• All of the above are marginal questions.
17.If Y = 200 + 2X, what is the slope of this line?• 100• 200• 2• 1/2• none of the above
18.If Y = 600 - 3X, what is the slope of this line?• -1/3• 1/3• 3• -3• 600
19.If Y = 600 - 3X, what is the vertical intercept?• 3• 200• 300• 600• none of the above
20.If Y = 600 - 3X, what is the horizontal intercept?• 100• 200• 300• 600• none of the above
2. Long Answer Questions
i. Looking at the world in which you find yourself in college,imagine a typical class day. What examples of the factors ofproductionare used to produce the class? What areexamples of natural resources, labor, physical capital,human capital, and entrepreneurship?
ii. “And now for something really interesting....” Near anddear to the heart of every student is a market — the marketfor textbooks. Write a short essay explaining how themarket for textbooks works on your campus — explainingwhat exactly takes place between you and the bookstore,both at the beginning and at the end of the term.
iii. Economists are often criticized for making assumptions.Why are assumptions necessary? To think about this, youmight consider an assumption that is often made: peopleare rational. Do you think that people are rational, and howcould you construct a model of irrational behavior? Wouldthat be a better assumption to make?
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There’s a famous saying that “learned economist,” is the onewho always answers “supply and demand” in response to everyquestion.Not fair, but ...It’s true that the “theory of supply and demand” is a centralpart of economics. It is widely applicable, and also is a modelof the way economists try to think most problems through,even when the theory of supply and demand is not applicable.When people’s actions are based on self-interest, peoplerespond to incentives, that is, to costs and benefits. When thecosts of an activity are raised or the benefits reduced, people doless of the activity. Economists have found that they can usethis simple idea of action based on costs and benefits toconstruct a model (or theory) that explains how many marketswork. This model, the model of supply and demand, isperhaps the most basic of the models economists use toexplain the world around us.Given the model’s importance in the way modern economiststhink, it is surprising that one does not find the model in thewritings of Adam Smith, David Ricardo, Thomas Malthus, orJohn Stuart Mill, though all of these pioneers in economicsused the words “supply” and “demand” frequently. Themodern supply-and-demand model does not appear until 1890,when Alfred Marshall published his Principles of Economics.This group of readings explores economic terms and conceptsthat follow directly from supply and demand curves and thatare important building blocks for other groups of readings. Itbegins with the concept of elasticity, which measures howpeople respond to changes. An elasticity computation can beused whenever a measurable change in something causes ameasurable change in behavior. We meet the most commonlyused elasticity measures: price elasticities of supply and demand,income elasticity, and cross-price elasticity. We then see howvalue can be represented on a demand-curve graph and meet the
UNIT IITHE CONSUMER MARKET
CHAPTER 2:SUPPLY AND DEMAND
very important concept of marginal: examining how marginal,total, and average revenue are related. Finally we learn thatelasticity and marginal revenue are related by means of a simpleequation.After you complete this chapter, you should be able to:• Define demand, supply, inferior good, normal good,
substitute, complement, law of demand, price taker, pricesearcher, market-clearing price.
• Distinguish between changes in demand and changes inquantity demanded.
• Distinguish between changes in supply and changes inquantity supplied.
• Predict how changes in factors such as income, prices ofsubstitutes, prices of inputs, etc. affect the supply anddemand curves and equilibrium quantity and price.
• Explain why we can treat the demand curve as positions ofbuyer equilibrium and the supply curve as positions of sellerequilibrium.
• Compute price elasticities of supply and demand when giventhe curves in the form of a table.
• Explain what is meant when one says demand is elastic orwhen one says demand is inelastic.
• Define income and cross-price elasticity, and explain whatthey measure.
• Compute marginal revenue when given total revenue, andvise versa.
• Compute average revenue when given total revenue, and viseversa.
• Explain why marginal revenue is the slope of the totalrevenue curve.
Recognize the area that represents total revenue on a demand orsupply graph.
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Before starting the lesson let me ask some questions to you :Why does someone like Michael Jordan make more money perseason than the rest of his team combined? Why are diamondsexpensive? Why do heart surgeons make more money thansanitation workers? You probably guessed it, supply anddemand. This unit will look at supply and demand and howthey interact in the marketplace to determine the prices we payfor the goods and services we purchase.Prices influence both buyers and sellers into making economicdecisions. If the price for computers goes down, it willstimulate more demand to purchase computers. If the price ofcorn goes up, it will stimulate farmers into producing morecorn. This is how the marketplace works. This section willlook at the market processes that influence the demand side ofthe equation.
3.1 Introduction to DemandA market exists when buyers and sellers interact to exchangeproducts. Supply and demand analysis describes what happensin only some of these interactions. To use supply and demandanalysis, we need markets in which there are many buyers andsellers, each small relative to the overall market. Also, bothbuyers and sellers must be well informed, and buyers and sellersmust form distinct and separate groups. If buyers are a groupdistinct from the sellers, we can analyse how the act separatelyfrom how sellers act. Only when we have looked at these twogroups separately will we combine them and see how theyinteract.What determines the amount of a product that people arewilling and ready to buy during some period of time? Forexample, what determines the amount of hamburger purchasedin Chicago during a week? Economists answer such questionsby examining the costs and benefits of buying the product.When any of the costs or benefits change, the amount of theproduct that people will buy should also change.The benefits a person gets from a product depend on his goals.These goals are referred to in many ways in discussions ofdemand. The words “tastes,” “wants,” “needs,” “prefer-ences,” and “usefulness” all refer to goals. When people’sgoals change, the amount of benefit they get from the goodchanges, and this will cause them to change the amount of thegood they want to buy.Goals (or preferences or tastes) depend on many factors, such asthe age of people and the amount of education they have.Social custom is an important determinant of preferences andcan account for many differences in demand among groups.One can explain the large differences in squid sales in Japan andthe United States, or the large differences in consumption ofhorse meat in Europe and the United States, almost entirely interms of differences in preferences caused by differences in socialcustom.
LESSON 3:DEMAND ANALYSIS
The most obvious cost a person bears in buying a product isthe price of the product. Price reflects cost because people have alimited amount of funds that they can spend, and if theyspend their money on one thing, they cannot spend it onanother. When the price of a product goes up, the amount ofother things that a person must give up in order to buy theproduct rises. As a result, we expect people to buy morehamburger if the price is $1.00 per pound than if it is $2.00 perpound.The amount of income a person receives affects the cost ofbuying an item because it determines which options a personmust give up when buying a product. If a person with a lowincome spends $5000 for a trip around the world, he will haveto cut back on food, clothing, or shelter. The same trip willcause a person with a high income to cut back on a very differentset of options.Increases in people’s incomes raise consumption of mostproducts. These products are called normal goods. There aresome products, however, that people use less of as theirincome increases; these products are called inferior goods.Public transportation is an example—as people’s incomes rise,they stop riding the bus and drive their own cars. Blue jeanswere once another example—people with higher incomesbought them less frequently than people with lower incomes. Itwas because they were a symbol of “working-class” clothes thatthey were adopted by the radical left in the 1960s, and fromthere they moved into high fashion.Prices of related goods also influence how much of a productpeople buy. Goods that are substitutes satisfy the same set ofgoals or preferences. An example of a substitute for hamburgeris pork. If pork prices are high, people are tempted to shift awayfrom pork to hamburger, and if pork prices are low, people aretempted to shift from hamburger to pork. The opposite of asubstitute is a complement, a good that helps completeanother in some way. Catsup and hamburger buns are comple-ments to hamburger, and if they are priced low enough,consumption of hamburger may rise. Sometimes goods aresuch good complements that they are sold together and wethink of them as a single item. Left shoes and right shoes are anexample.There are other factors that influence the amount of a particularproduct that people are willing to buy, such as the number ofconsumers in the market and their expectations about futureprices, incomes, and quality changes. To get a complete list forany product might be time consuming and difficult, but it isnot necessary because we want to focus on the relationshipbetween price and the quantity of a product that people arewilling to buy during some interval of time. To do this, we willassume that all other factors are held constant.
3.2 Demand Schedule & Demand Curve
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The relationship between price and the amount of a productpeople want to buy is what economists call the demand curve.This relationship is inverse or indirect because as price getshigher, people want less of a particular product. This inverserelationship is almost always found in studies of particularproducts, and its very widespread occurrence has given it aspecial name: the law of demand. The word “law” in this casedoes not refer to a bill that the government has passed but toan observed regularity.There are various ways to express the relationship between priceand the quantity that people will buy. Mathematically, one cansay that quantity demanded is a function of price, with otherfactors held constant, or:Qd = f(Price, other factors held constant)A more elementary way to capture the relationship is in theform of a table. The numbers in the table below are what oneexpects in a demand curve: as price goes up, the amount peopleare willing to buy decreases. This tabular representation isknown as Demand Schedule (A widget is an imaginaryproduct that some economist invented when he could notthink of a real product to use in illustrating an idea.)
A Demand Schedule
Price of Widgets Number of Widgets People Want to Buy
$1.00 100 $2.00 90 $3.00 70 $4.00 40
The same information can also be plotted on a graph, where itwill look like the graph below. 1 This graphical representation isknown as Demand Curve.
3.3 Law of DemandThe graph above also demonstrates the law of demand. Thelaw of demand states that as price decreases, quantitydemanded increases. An inverse relationship exists. The lawof demand is dependent on ceteris paribus- all other factorsremaining unchanged.These other factors are the assumptions of the law as well.1. Price of related goods should remain unchanged.2. Income of the consumer should not change.3. Taste, preferences & fashion should not change.4. All the units of product in question are homogeneous.
In economics, the term utility refers to the measure of satisfac-tion received from consuming a good or service. The law ofdemand does not go on for infinity. There are limits. The lawof diminishing marginal utility describes how the last itemconsumed will be less satisfying than the one before. Thismeans at some point, no matter how low the price is, consum-ers will purchase less.
3.4 Change in Demand & Shift in DemandA change in quantity demanded can be illustrated by amovement between points along a stationary demand curve.Once again, demand is influenced by price. On the demandcurve above, this is seen in the movement from point A topoint B.A shift in demand can also occur. A shift in demand refers toan increase (rightward change) or decrease (leftward change) inthe quantity demanded at each possible price. This shift isinfluenced by non-price determinants. An example of anincrease and a decrease in demand are pictured below.If one of the factors being held constant becomes unstuck,changes, and then is held constant again, the relationshipbetween price and quantity will change. For example, supposethe price of getwids, a substitute for widgets, falls. Then,people who previously were buying widgets will reconsider theirchoices, and some may decide to switch to getwids. This wouldbe true at all possible prices for widgets. These changes in theway people will behave at each price will change the demandcurve to look like in the table below.
A Demand Curve Can Shift
Price of Widgets Number of Widgets People Want to Buy
$1.00 [100] becomes 80 $2.00 [90] becomes 70 $3.00 [70] becomes 50 $4.00 [40] becomes 10
These are the same changes shown in a graph.
For all theoretical purpose we will assume the demand curve tobe a straight line. Shift in demand can either be increase ordecrease, shown in graph below• Increase in demand, resulting from increase is the price of
substitute, or increase in income, or change in taste &preferences etc. the graph will be one as below.
• Decrease in demand, resulting from decrease is the price ofsubstitute, or decrease in income, or change in taste &preferences etc. the graph will be one as below.
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The most important distinction to keep in mind is that achange in quantity demanded is a movement along a singlecurve, while a shift in demand involves the creation of a secondcurve.
3.3 Non-Price Determinants of DemandThere are other factors besides price that influence consumers topurchase products. A brief description of each is providedbelow.1. A Change in income. If you receive a raise you are likely to
increase your demand for goods. If you get laid off, yourdemand for goods will likely decrease. When incomeincreases, consumers buy more. When income decreases,consumers buy less.
2. A Change in taste. Fads, fashions, and the advertising ofnew products influence consumer decisions. Think of hulahoops and Pokeman cards.
3. A Change in the price of a substitute good. A substitutegood competes with another good for consumer purchases.Examples of substitute goods include juice and soda,margarine and butter, and audio cassette tapes and compactdiscs. If the price of soda increases too much, consumermay decide to drink juice instead.
4. A Change in the price of a complementary good. Acomplementary good is jointly consumed with anothergood. Examples include cars and gasoline, tuition andtextbooks, and milk and cereal. If the price of milk increasesdramatically, consumers will decide to purchase less milk, andconsequently, less cereal.
5. A Change in buyer expectations. If consumers think theprice of a good will increase in the future, they may decide tobuy more of it now so that they pay less. Suppose that a
storm damages a large part of the orange crop. Consumersmay run out and buy all the oranges they can find inanticipating the price of oranges increasing.
6. A Change in the Number of Buyers. Population growthwill increase the demand for products because the pool ofconsumers has grown. Population decline will have theopposite effect. Look at the Baby Boom generation and howthey have affected demand for goods over the course of theirlifetimes.
A good place to end is to summarize the lesson. Demandrefers to the quantities of a product that people are willing andable to purchase at a given price during some period of time.The term quantity demanded refers to a point on the demandcurve- the quantity demanded at a particular price. A demandcurve can be used to illustrate the relationship between quantitydemanded and price.
3.4 SummaryTo sum up I can say always remember when we speak of“demand” we usually mean the entire demand relationship, that is,the entire demand curve or table. By contrast, the “quantitydemanded” is the particular point on the demand curve, as inFigure 2 below, or the quantity in a particular line of the table
Figure 2: Demand Terminology
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LESSON 4:SUPPLY ANALYSIS
Why is it that farmers are more willing to grow certain crops oneyear and different crops the next? The price they receive for thecrop they grow determines what seeds the farmers will sow.The information below will help you to understand the supplyside of the equation.
4.1 Supply DefinedWhat determines the amount of a good or service that peopleare willing and ready to sell during some period of time? Adiscussion of exchange suggested that people sell thingsbecause it is a way, indirect but effective, of obtaining otherthings that they prefer. Sellers intend to make a profit from theirsales, and economists assume that they want their profits to beas large as possible. Because profit is the difference betweenbenefits in the form of revenues and costs, anything thatinfluences revenues or costs can influence the amounts sellerswant to sell.Supply focuses on the producer of goods and services. Supplyrefers to the quantities of a product that producers arewilling and able to offer at a given price during someperiod of time. Like demand, there are price and non-pricedeterminants for supply. Producers make decisions on howmuch to supply based on profitability.Revenue is found by multiplying the price of the product by theamount sold. A change in price changes revenues, and henceprofits, so it is a major determinant of the amount sellers willwant to sell. Because a higher price leads to higher profit, and ahigher profit leads to a larger amount that sellers will want tosell, one expects that a greater quantity should be supplied whenthe price is higher. Thus, the relationship between quantity thatsellers will sell and price should be direct or positive.Though the positive relationship is almost always the case, thereare a few exceptions. An example is labor; as wages go up,people may decide to enjoy their higher wages and work less. Asa result, there is no law of supply that matches the law ofdemand.The cost of something is what must be given up in order to getit. When costs are only monetary, they are easy to see. If theprice of an input increases, the cost of the output will increase,and, other things held constant, profits will decrease. The sellerwill then have to decide if shifting part of his resources andeffort to other products will improve his well-being.Production costs are determined not only by the prices ofinputs, but also by technology. Technology represents theknowledge of how inputs (such as labor, raw materials, energy,and machinery) can be combined to produce the product. Ifthis knowledge increases so that people find cheaper ways tomake the same output, then, other things held constant, profitincreases and we expect sellers to respond by producing more.Costs may be nonmonetary as well as monetary. For example, afarmer takes the expected price of soybeans into account in
deciding how much corn to plant. If soybeans are expected tosell for a high price, then the farmer may find that shifting someof his land from corn production to soybean production willincrease profit. The decision to plant corn means that the farmergives up the opportunity to plant soybeans (as well as giving upthe money for seed, fuel, equipment, and labor). Because wehave defined cost as what must be given up to get something,the prices of other goods that sellers could otherwise produceand sell must be part of the calculation of the cost of produc-tion.There are other factors that can influence the amount of aproduct that sellers will sell, such as the number of sellers,expectations about the future, and whether or not there are by-products in production that are valuable. (An example of avaluable by-product is cottonseed in the production of cotton.A farmer who produces cotton also gets cottonseed, whichyields cottonseed oil, a widely used vegetable oil.) But as in thediscussion of demand, the emphasis in the discussion ofsupply is on the relationship between quantity and price. Tofocus on this relationship, all other factors must be assumed tobe constant.The supply side of the equation also has a law . The law ofsupply states that sellers will offer more of a good at ahigher price and less at a lower price. This law can also begraphically displayed.
4.2 The Supply Schedule & Supply CurveThe relationship between the quantity sellers want to sell duringsome time period (quantity supplied) and price is whateconomists call the supply curve. Though usually the relation-ship is positive, so that when price increases so does quantitysupplied, there are exceptions. Hence there is no law of supplythat parallels the law of demand.The supply curve can be expressed mathematically in functionalform asQs = f(price, other factors held constant).It can also be illustrated in the form of a table or a graph. Thetabular representation is known as Supply Schedule, whereasgraphical representation is called as Supply Curve
A Supply Schedule
Price of Widgets Number of Widgets Sellers Want to Sell
$1.00 10 $2.00 40 $3.00 70 $4.00 140
The graph shown below has a positive slope, which is the slopeone normally expects from a supply curve.
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For all practical purpose we assume this curve as a straight line.This will be clear when you examine the following curve :
A change in Quantity supplied occurs when there is amovement between points along a stationary supply curve.Once again, this movement is influenced by price. This changecan be seen in the graph above with the movement from pointA to point B.There can also be a shift in supply. A shift in supply refers toan increase (rightward change) or a decrease (leftward change) inthe quantity supplied at each possible price. These shifts areinfluenced by non-price determinants.
4.3 Shift in Supply
If one of the factors that is held constant changes, the relation-ship between price and quantity, (supply) will change. If theprice of an input falls, for example, the supply relationship maychange, as in the following table.
A Supply Curve Can Shi f t
Price of Widgets Number of Widgets Sellers Want to Sell
$1.00 [10] becomes 20 $2.00 [40] becomes 60 $3.00 [70] becomes 100 $4.00 [140] becomes 180
The same changes can be shown with a graph.
As I have already said that theoretical purpose we will assumethe supply curve to be a straight line. This shift in demand caneither be increase or decrease, shown in graph below• Increase in demand, resulting from increase is the price of
substitute, or increase in income, or change in taste &preferences etc. the graph will be one as below.
Decrease in demand, resulting from decrease is the price ofsubstitute, or decrease in income, or change in taste & prefer-ences etc. the graph will be one as below.
The most important distinction to keep in mind is that a change inquantity supplied is a movement along a single curve, while a shift insupply involves the creation of a second curve.
4.4 Non-Price Determinants of SupplyThere are other factors besides price that influence producers tosell products. A brief description of each is provided below. 1. Change in technology. New, efficient technology makes it
possible to offer more products at any possible selling price.Technology such as computers and robots have made itpossible to reduce production costs and increase the supplyof goods and services.
2. Change in production costs. A change in the cost of labor,or taxes, or a resource needed to produce a good, impacts thedecisions of sellers on how much to produce.
3. Change in the number of sellers. An increase or decreasein the number of sellers can influence the production ofgoods and services. If the United States removes arestriction of foreign imports, then there are more sellers inthe market.
4. Change in supplier expectations. Expectations of thefuture can influence the production of goods and services.If prices of a good or service is expected to rise in the future,sellers may hold back production in the present in the hopesof making more profit by selling more in the future. Forexample, if farmers think the future of the price of corn todecline, they will increase the present supply of corn, in thehopes of making more money now.
4.5 Supply Terminology
As with demand, economists separate changes in the amountthat sellers will sell into two categories. A change in supplyrefers to a change in behavior of sellers caused because a factorheld constant has changed. As a result of a change in supply,there is a new relationship between price and quantity. At eachprice there will be a new quantity and at each quantity there willbe a new price. A change in quantity supplied refers to achange in behavior of sellers caused because price has changed.In this case, the relationship between price and quantity remains
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unchanged, but a new pair in the list of all possible pairs ofprice and quantity has been realized.Supply curves as well as demand curves appear much moreconcrete on an economist’s graph than they appear in realmarkets. A supply curve is mostly potential—what will happenif certain prices are charged, most of which will never becharged. From the buyer’s perspective, the supply curve hasmore meaning as a boundary than as a relationship. The supplycurve says that only certain price-quantity pairs will be availableto buyers—those lying to the left of the supply curve.
4.6 The Long and Short RunHere’s a complication: The supply relationship will depend onhow long the suppliers have to adjust to a change in the price.With respect to supply, time plays a role that it does not (inmost cases) play in the case of demand. If there is plenty oftime for the suppliers to adjust to a change in the price, we havea long run analysis. This means the sellers can invest andexpand productive capacity, in response to a high price, or cangradually reduce the productive capacity by under-replacingworn-out equipment in the case of a low price. However, if thesellers are not sure the high or low price will continue for a longtime, a short run analysis may be more appropriate. In a shortrun analysis, we treat the plant and equipment of the industryas inflexibly given. In that case, output can be increased only byusing that fixed plant and equipment more intensively. Thus,we would expect the adjustment of supply to a change in priceto be more complete in the long run than in the short run.We do not ordinarily apply the long run versus short rundistinction to demand, but there are some special cases where itmight be important. For example, for durable goods such ascars, buyers might adjust less completely in the short run thanin the long, since they can postpone replacement of theirdurable goods until the price comes down. In the long run, thegoods wear out and so the consumers cannot postponereplacement long enough.In summary,• In the short run the plant and equipment (productive
capacity) of the industry are fixed• In the long run sellers can change the productive
capacity, in response to the priceNext I will take up the Equilibrium of demand & supply.
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LESSON 5:EQUILIBRIUM OF SUPPLY AND DEMAND
5.1 Introduction to EquilibriumNow that we have introduced the concepts of supply anddemand separately — with illustrative examples of the demandfor, and supply of, beer — it is time to move on from analysisto synthesis, and put the two concepts together. In economictheory, the interaction of supply and demand is understood asequilibrium.We may think of demand as a force tending to increase the priceof a good, and of supply as a force tending to reduce the price.When the two forces balance one another, the price wouldniether rise nor fall, but would be stable. This analogy leads usto think of the stable or natural price in a particular market asthe “equilibrium” price.This sort of “equilibrium” exists when the price is just highenough so that the quantity supplied just equals the quantitydemanded. If we superimpose the demand curve and thesupply curve in the same diagram, we can easily visualize this“equilibrium” price. It is the price at which the two curves cross.The corresponding quantity is the quantity that would be tradedin a market equilibrium.We have already developed two behavioral statements, orassertions, about how people will act. The first says that theamount buyers are willing and ready to buy depends on priceand other factors that are assumed constant. The second saysthat the amount sellers are willing and ready to sell depends onprice and other factors that are assumed constant. In math-ematical terms our model isQd = f(price, constants)Qs = g(price, constants)This is not a complete model. Mathematically, the problem isthat we have three variables (Qd, Qs, price) and only twoequations, and this system will not have a solution. Tocomplete the system, we add a simple equation containing theequilibrium condition:Qd = Qs.In words, equilibrium exists if the amount sellers are willing tosell is equal to the amount buyers are willing to buy.If we combine the supply and demand tables in earlier sections,we get the table below. It should be obvious that the price of$3.00 is the equilibrium price and the quantity of 70 is theequilibrium quantity. At any other price, sellers would want tosell a different amount than buyers want to buy.
Supply and Demand Together at Last
Price of Widgets Number of Widgets People Want to Buy
Number of Widgets Sellers Want to Sell
$1.00 100 10 $2.00 90 40 $3.00 70 70 $4.00 40 140
The same information can be shown with a graph. On thegraph, the equilibrium price and quantity are indicated by theintersection of the supply and demand curves.
If one of the many factors that is being held constant changes,then equilibrium price and quantity will change. Further, if weknow which factor changes, we can often predict the direction ofchanges, though rarely the exact magnitude. For example, themarket for wheat fits the requirements of the supply anddemand model quite well. Suppose there is a drought in themain wheat-producing areas of the United States. How will weshow this on a supply and demand graph? Should we move thedemand curve, the supply curve, or both? What will happen toequilibrium price and quantity?A dangerous way to answer these questions is to first try todecide what will happen to price and quantity and then decidewhat will happen to the supply and demand curves. This is aroute to disaster. Rather, one must first decide how the curveswill shift, and from the shifts in the curves decide how price andquantity would change.What should happen as the result of the drought? One beginsby asking whether buyers would change the amount theypurchased if price did not change and whether sellers wouldchange the amount sold if price did not change. On reflection,one realizes that this event will change seller behavior at thegiven price, but is highly unlikely to change buyer behavior(unless one assumes that more than the drought occurs, such asa change in expectations caused by the drought). Further, at anyprice, the drought will reduce the amount sellers will sell. Thus,the supply curve will shift to the left and the demand curve willnot change. There will be a change in supply and a change inquantity demanded. The new equilibrium will have a higherprice and a lower quantity. These changes are shown below.
What should one predict if a new diet calling for the consump-tion of two loaves of whole wheat bread sweeps through theU.S.? Again one must ask whether the behavior of buyers or
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sellers will change if price does not change. Reflection shouldtell you that it will be the behavior of buyers that will change.Buyers would want more wheat at each possible price. Thedemand curve shifts to the right, which results in higherequilibrium price and quantity. Sellers would also change theirbehavior, but only because price changed.Next we reflect on some assumptions we have made.
5.2 Assumptions
The supply and demand model does not describe all mar-kets—there is too much diversity in the ways buyers and sellersinteract for one simple model to explain everything. When weuse the supply and demand model to explain a market, we areimplicitly making a number of assumptions about that market.For a supply curve to exist, there must be a large number ofsellers in the market; and for a demand curve to exist, theremust be many buyers. In both cases there must be enough sothat no one believes that what he does will influence price. Interms that were first introduced into economics in the 1950sand that have become quite popular, everyone must be a pricetaker and no one can be a price searcher. If there is only oneseller, that seller can search along the demand curve to find themost profitable price. 1 A price taker cannot influence the price,but must take or leave it. The ordinary consumer knows therole of price taker well. When he goes to the store, he can buyone or twenty gallons of milk with no effect on price. Theassumption that both buyers and sellers are price takers is acrucial assumption, and often it is not true with regard tosellers. If it is not true with regard to sellers, a supply curve willnot exist because the amount a seller will want to sell willdepend not on price but on marginal revenue.The model of supply and demand also requires that buyersand sellers be clearly defined groups. Notice that in the listof factors that affected buyers and sellers, the only commonfactor was price. Few people who buy hamburger know or careabout the price of cattle feed or the details of cattle breeding.Cattle raisers do not care what the income of the buyers is orwhat the prices of related goods are unless they affect the priceof cattle. Thus, when one factor changes, it affects only onecurve, not both. When buyers and sellers cannot be clearlydistinguished, as in the New York Stock Exchange, where thepeople who are buyers one minute may be sellers the next, onecannot talk about distinct and separate supply and demandcurves.The model of supply and demand also assumes that bothbuyers and sellers have good information about theproduct’s qualities and availability. If information is notgood, the same product may sell for a variety of prices. Often,however, what seems to be the same product at different pricescan be considered a variety of products. A pound of hamburgerfor which one has to wait 15 minutes in a check-out line can beconsidered a different product from identical meat that one canbuy without waiting.In addition, the supply and demand model needs well-definedprivate-property rights. Elsewhere, we discussed how private-property rights and markets provide one way of coordinatingdecisions. When property rights are not clearly defined, the sellermay be able to ignore some of the costs of production, which
will then be imposed on others. Alternatively, buyers may notget all the benefits from purchasing a product; others may getsome of the benefits without payment.Finally, the supply and demand model requires many buyersand sellers. If there is only one seller, the seller can search alongthe demand curve of the buyers for the position that is mostprofitable. In this case, it is not just price that matters, but theslope of the demand curve as well. The seller in this case is nota price taker, but a price searcher.Even if the assumptions underlying supply and demand arenot met exactly, and they rarely are, the model often provides afairly good approximation of a situation, good enough so thatpredictions based on the model are in the right direction. Thisability of the model to predict even when some assumptionsare not quite satisfied is one reason economists like the modelso much.Next we discuss the process of adjustment.
5.3 Buyers EquilibriumWe have developed the model of supply and demand as anequilibrium model. We have said nothing about how adjust-ments from disequilibrium to equilibrium take place. Todevelop this idea, it is useful to take still another view of supplyand demand curves, to view demand as points of buyerequilibrium and supply as points of seller equilibrium.
Suppose that price is at P1 in the graph above. Will point a be apoint on the demand curve? If people would like to buy morethan Q1 at price P1, point a must lie to the left of the demandcurve. In this case, some consumers are unhappy with theamount they have purchased, and will try to purchase more. Ifthere is no more to purchase, some will attempt to offer moremoney for the product, or they will increase the time theydevote to getting the product. The important idea is that ifpoint a lies to the left of the demand curve, people will beunhappy with their situation and will change their behavior. Ifpoint a lies to the right of the demand curve, people will decidethat they are buying too much of the product and will cutpurchases. In conclusion, if a position is not on the demandcurve, people will change their behavior, which indicates thatonly positions on the demand curve are positions of buyerequilibrium.Similar reasoning explains why the demand curve can beconsidered a boundary. In the graph below, buyers are not inequilibrium at point a, but they can be held there and made toadjust in ways that do not change the money price. They cannotbe held at point c unless there is some way to force people tobuy a product when they do not want it.
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Point b in the graph is a position of buyer equilibrium becausegiven price P1, people will be satisfied with Q1 and will donothing to change their behavior. Buyers would, of course,prefer a lower price than P1—they are always willing to movedown the demand curve. However, this is not the issue here.Given P1, Q1 is the preferred quantity.A similar analysis holds for the supply curve.
5.4 Sellers EquilibriumJust as the demand curve shows positions of buyer equilib-rium the supply curve shows positions of seller equilibrium.At point a in the picture below suppliers find that they couldincrease profits (or reduce losses) by moving to the right to alarger quantity. If they could not increase profits by movingtoward the right, they would stay at point a. Because they donot, they are not in equilibrium and on the supply curve but tothe left of it. If they find that they could increase profits bycutting production, they are to the right of the supply curve andout of equilibrium. There is a quantity at the price P1 thatmaximizes profits and toward which sellers will adjust. Thispoint, shown as b in the picture, is on the supply curve.
It is possible to force a seller to a position left of the supplycurve. This is the case in which the seller would like to sell moreat the given price, but for some reason can not. One reasonmight be that the buyers will not buy as much as the sellerswould like to sell. It is virtually impossible—short of slavery—to force sellers to the right of the supply curve. This is thesituation in which sellers are selling more than they want to atthe given price. Thus, the supply curve represents a boundaryfacing the buyers. If buyers could force sellers to the right of thesupply curve, they would find it advantageous to force sellers toa position such as x in graph above, which represents gettingsomething for nothing.
5.4.1 Shortage and SurplusSellers prefer higher prices to lower prices. Although all pointson the supply curve represent points of equilibrium, not all areequally preferred by sellers.
The above analysis helps explain how an adjustment processtakes place in the supply and demand model. If price isoriginally P1 in the graph below, only Q1 will be sold eventhough buyers would like to buy Q2. The difference Q2 - Q1represents a shortage. The sellers are in equilibrium in thissituation because they can sell everything they want to sell at thisprice, but buyers are not. Some buyers who cannot obtain theproduct are willing to offer more, and sellers are always willingto accept a higher price. Therefore, the actions of the buyers, asthey compete with each other to obtain the amount that isavailable, drive the price upward in this model toward marketequilibrium.
If price is originally at P2 in the picture below, only Q1 will besold because this is all that buyers will purchase, even thoughsellers are willing to sell more, Q2. The difference Q2 - Q1 iscalled a surplus. In this situation the buyers are in equilibriumbecause they can buy all they want to buy at the going price.However, the sellers are not in equilibrium and will competeamong themselves to get rid of the surplus. Some sellers willbe willing to offer their product at a lower price. Buyers arealways willing to move down the demand curve, so there is atendency to move downward toward market equilibrium in thepicture below.
If left to itself, a supply-and-demand market tends to adjust tothe point where the supply and demand curves cross. The priceat this intersection is called the market-clearing price. Thereis, however, the possibility that the existence of lags in theadjustment process may make the adjustment more complexthan the previous discussion indicates.Suppose that the price of cattle feed rises sharply. This eventshould affect the supply curve of cattle by shifting it to the left.The profitability of cattle production is reduced at each possibleprice, and some producers will drop out of the industry whileothers will curtail production. Looking at the curves, we see thatprices should rise and quantity should drop.However, initially
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prices might drop and quantity might rise, which is the exactopposite of the prediction from the supply and demand graph.The higher costs of feed will encourage farmers to raise fewercattle, but as part of that cutback, they will temporarily sendmore cattle to the slaughterhouses. The prediction that supply-demand analysis gives will ultimately be correct, but it will notbe correct in the process of adjustment.More complicated adjustment patterns are possible. Suppose,for example, that higher beef prices shift the demand for porkto the right. Supply and demand analysis says that this shouldincrease pork prices, and at the higher prices, farmers shouldproduce more hogs.However, hog production takes time, and will only happen iffarmers expect the higher prices to continue for a long time. Ifpork producers do expect the higher prices to last, they maydecrease the number of pigs sent to slaughter, further increasingprice. A sow can either produce pork or baby pigs, but notboth. If farmers expect high prices to last, they will keep theirsows for piglet production.In six months to a year, the baby pigs will have grown enoughto go to market. If enough farmers had expected the high pricesto last, they may have produced so many pigs that pork priceswill now plunge to a level below that which is considerednormal. The new, abnormally low price can then influencedecisions that will not affect the price for many months. Youshould see that, once disturbed, a market with long time lags inproduction may bounce around for years before it finally findsits way back to equilibrium. If such a market is disturbed oftenenough, its prices and quantities will never come to rest atequilibrium levels.Microeconomic discussion generally ignores adjustmentproblems, at least at the introductory level. Microeconomicsassumes that markets clear, that is, they are always in equilib-rium. Its analysis begins with the assumption that equilibriumhas been reached and then asks questions about that equilib-rium. However, adjustment problems are very important inmacroeconomics . Macroeconomics cannot assume there are noadjustment problems, or else it assumes away one of theproblems it wants to explain, unemployment. In fact, much ofmacroeconomics is about the forces that bump an economyaway from equilibrium, and why, once it is away, it has prob-lems reaching a new equilibrium.
5.4 Competition and EquilibriumWhat we have seen is that the price will be in constant motion,up or down, except when quantity demanded is equal toquantity supplied. That is the position of rest.Put another way, it is the price toward which competitionpushes the price. At equilibrium, there is no competition eitherto buy or to sell, because everyone can buy or sell however muchthey may wish, at the going price. But whenever the market isaway from equilibrium, competition will arise and tend to forceit back.Competition eliminates itself, by forcing the market into anequilibrium in which there is no need to compete. (This is a verydifferent concept of competition than the biological “strugglefor survival!)
Notes
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6.1 Price ElasticityBusinesses know that they face demand curves, but rarely dothey know what these curves look like. Yet sometimes abusiness needs to have a good idea of what part of a demandcurve looks like if it is to make good decisions. If Rick’s Pizzaraises its prices by ten percent, what will happen to its revenues?The answer depends on how consumers will respond. Will theycut back purchases a little or a lot? This question of howresponsive consumers are to price changes involves the eco-nomic concept of elasticity.Elasticity is a measure of responsiveness. Two words areimportant here. The word “measure” means that elasticityresults are reported as numbers, or elasticity coefficients. Theword “responsiveness” means that there is a stimulus-reactioninvolved. Some change or stimulus causes people to react bychanging their behavior, and elasticity measures the extent towhich people react.1
The most common elasticity measurement is that of priceelasticity of demand. It measures how much consumersrespond in their buying decisions to a change in price. The basicformula used to determine price elasticity ise = (percentage change in quantity) / (percentage change inprice).(Read that as elasticity is the percentage change in quantitydivided by the percentage change in price.)If price increases by 10% and consumers respond by decreasingpurchases by 20%, the equation computes the elasticity coeffi-cient as -2. The result is negative because an increase in price (apositive number) leads to a decrease in purchases (a negativenumber). Because the law of demand says it will always benegative, many economists ignore the negative sign, as we willin the following discussion.An elasticity coefficient of 2 shows that consumers respond agreat deal to a change in price. If, on the other hand, a 10%change in price causes only a 5% change in sales, the elasticitycoefficient will be only 1/2. Economists would say in this casethat demand is inelastic. Demand is inelastic whenever theelasticity coefficient is less than one. When it is greater than one,economists say that demand is elastic.Products that have few good substitutes generally have a lowerelasticity of demand than products with many substitutes. As aresult, more broadly defined products have a lower elasticitythan narrowly defined products. The price elasticity of demandfor meat will be lower than the price elasticity of pork, and theprice elasticity for soft drinks will be less elastic than the priceelasticity for colas, which in turn will be less elastic than the priceelasticity for Pepsi.Time plays an important role in determining both consumerand producer responsiveness for many items. The longerpeople have to make adjustments, the more adjustments they
LESSON 6:ELASTICITY OF SUPPLY AND DEMAND
will make. When the price of gasoline rose rapidly in the late1970s as a result of the OPEC cartel, the only adjustmentconsumers could initially make was to drive less. With time,they could also move closer to work or find jobs closer tohome, and switch to more fuel-efficient cars.The concept of elasticity can help explain some situations that atfirst glance may seem puzzling. If American farmers all haveexcellent harvests, they may have a very poor year financially.They may be better off if they all have mediocre harvests. If abus company decides it needs more revenue and tries to get itby raising fares, its revenues may decrease rather than increase.
In the case of the farmers, the key to their problem is that thedemand curve for their products is quite inelastic. This meansthat if the harvest is unusually good, a large drop in price isnecessary to encourage consumers to use the additional grain. Ifthe elasticity coefficient is .5, for example, and the harvest is 10%larger than the previous year, then a 20% drop in prices willoccur (assuming that the many things that we keep constant indrawing the demand curve have remained constant). Becausethis price reduction more than offsets the effect of the largerharvest, the average farmer’s income drops.
For the bus company, the key is that demand is elastic. Forexample, suppose that the elasticity is 1.5. Then, if price is raisedby 10%, quantity (ridership) must drop by 15%. But the dropin ridership more than offsets the increase in price, and sorevenue will drop.Just as we can measure how responsive buyers are to a change inprice, we can measure how responsive sellers are. This measure-ment, the price elasticity of supply, has the same formula asprice elasticity of demand, only the quantity in the formula willrefer to the quantity that sellers will sell.
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As with demand elasticity, supply elasticity depends on theamount of time available for adjustment. In the very short run,there may be no adjustments they can make, which would meana perfectly vertical supply curve. For example, if on December 1the price of apples doubles, there will be minimal effect on thenumber of apples available to the consumer. Producers cannotmake adjustments until a new growing season begins. In theshort run, producers can use their facilities more or lessintensively. In the apple example, they can vary the amounts ofpesticides, and the amount of labor they use to pick the apples.Finally, in the long run, not only can producers change theirfacilities, but they can also leave the industry or new producersmay enter it. In our apple example, new orchards can be plantedor old ones destroyed.
6.2 Types of Price Elasticity of DemandDifferent commodities respond differently to changes in theirprice. A price change has relatively much less impact on quantitydemanded of a necessity than it has on the quantity demandedo f a luxury. In fact, it is the nature o f a commodity which isresponsible for differing elasticities of demand in case ofdifferent commodities. Conceptually price elasticities of demandis generally classified into the following categories:1. Perfectly elastic demand (e = (0). Where no reduction in
price is needed to cause an increase in quantity demanded[figure (a)];
2. Absolutely inelastic demand (e = 0). Where a change inprice, however large, causes no change in quantity demanded[Fig. (b)];
3. Unit elasticity of demand (e = 1). Where a givenproportionate change in price causes an equally proportionatechange in quantity demanded (in this case the demand curvetakes the form o f a rectangular hyperbola. [Fig. (c)];
4. Relatively elastic demand (e > 1). Where a change in pricecauses a more than proportionate change in quantitydemanded [Fig. (d)]
5. Relatively inelastic demand (e < 1). Where a change inprice causes a less than proportionate change in quantitydemanded [Fig. (e)].
Now comes the technical stuff, a discussion on how tocompute price elasticity.
6.3 Computing Price Elasticity(Warning: This section involves some simple algebra. If you aremath-challenged, take it slowly and it will probably be OK.)You can calculate elasticity in two different ways:1. Point Elasticity2. Arc ElasticityWhen we try to use the equation in the first section to calculateelasticity coefficients, we run into a problem. If we look at anincrease in price from $3.00 to $4.00, we have an increase of33%. However, if we have a price reduction from $4.00 to$3.00, we have a reduction of 25%. Thus, there are two ways ofviewing what happens between $3.00 and $4.00.Suppose that when price of a product is $3.00, people will buy60, but when price is $4.00, they will buy only 50. What is theelasticity over this segment of the demand curve, between prices$3.00 and $4.00? Should one start at the price of $3.00 andcompute a price rise of 33 1/3% and a quantity decline of 16 2/3%, ore =(16.67%)/(33.33%) = .5.Or, should one start at the $4.00 price, and compute a pricedecline of 25% and a quantity increase of 20%, ore = (20%)/(25%) = .8.The formula mentioned in the previous section does not tell uswhich way to proceed, and it matters. To get around theproblem of deciding which starting point to use, economistscompute elasticity based on the midpoint, or in the exampleabove, at a price of $3.50. The formula that does this ise = (Change in quantity divided by average quantity) / (Changein price divided by average price)ore = ((Q1 - Q2) / (Q1 + Q2)/2 )) / ((P1 - P2)/((P1 + P2)/2)).Putting the numbers from the previous example into thisequation yields:e = (60-50)/ (60+50)/2 divided by ($4-$3) / ($4+$3)/2ore = (10/55)/(1.00 /3.50) = (10/55)x(35/10) = 7/11 = .6363...This formula is the formula for arc elasticity, or the elasticitybetween two points on the demand curve. As the two pointsget closer together, arc elasticity approaches point elasticity, themeasure of elasticity preferred by professional economists.With a bit of algebra, one can show that the equation forelasticity above can be rewritten as:e = (1 / (Slope of Demand Curve)) multiplied by ((AveragePrice)/(Average Quantity))Using this last equation, consider what happens when the slopegets steeper, which means that the slope becomes a biggernumber.1 Elasticity becomes smaller, which means thatconsumers are less responsive. As the demand curve approachesa vertical line, the slope approaches infinity and elasticityapproaches zero. As the demand curve approaches a horizontalline, the slope approaches zero and elasticity approaches infinity.
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One can also see what happens when the slope is constant,which means that the demand curve is a straight line. As onemoves along the line, elasticity changes because average price andaverage quantity change. At the top of the demand curve, priceis high and quantity is low, so elasticity is high. At the bottomprice is low and quantity is high, so elasticity is low.Wow. You’ve made it through all that technical stuff. Now, youcan relax a bit and look at some other things that can bemeasured with the elasticity concept.
6.4 Other ElasticitiesIn addition to price elasticities of supply and demand, econo-mists frequently refer to other elasticity measurements. Incomeelasticity of demand measures the responsiveness ofpeople’s purchases to changes in income. It is defined asIncome Elasticity = (percentage change in amount bought)divided by (percentage change in income)Income elasticity measures whether a good is a normal or aninferior good. A product is a normal good when its incomeelasticity is positive, meaning that higher income causes peopleto purchase more of the product. For an inferior good, incomeelasticity is negative because an increase in income causes peopleto buy less of the product.Cross-price elasticity, often simply called just cross-elasticity,measures whether goods are substitutes or complements. Itlooks at the response of people in buying one product whenthe price of another product changes. The formula for cross-price elasticity isCross-Price Elasticity = (percentage change in amount of Abought) divided by (percentage change in price of B).If goods are complements, cross-price elasticity will be negative.For example, if the price of gasoline rises, the sales of large carswill decline. The positive change in the denominator (bottom)is matched with a negative change in the numerator (top) of theequation. The result is therefore negative. If cross-price elasticityis positive, B is a substitute for A. For example, sales of Cokewill fall if the price of Pepsi falls because some Coke drinkerswill switch from Coke to Pepsi.Next lets shift gears and see how revenue and the demand curveare related.
6.5 Revenue And DemandThe demand curve is a tremendously useful illustration forthose who can read it. We have seen that the downward slopetells us that there is an indirect relationship between price andquantity. One can also view the demand curve as separating aregion in which sellers can operate from a region forbidden tothem. But there is more, especially when one considers what anarea on the graph represents.If people will buy 100 units of a product when its price is$10.00, as the picture below illustrates, total revenue for sellerswill be $1000. Simple geometry tells us that the area of therectangle formed under the demand curve in the picture isfound by multiplying the height of the rectangle by its width.Because the height is price and the width is quantity, and sinceprice multiplied by quantity is total revenue, the area is totalrevenue. The fact that area on supply and demand graphs
measures total revenue (or total expenditure by buyers, which isthe same thing from another viewpoint) is a key idea usedrepeatedly in microeconomics.
From the demand curve, we can obtain total revenue. Fromtotal revenue, we can obtain another key concept: marginalrevenue. Marginal revenue is the additional revenue added byan additional unit of output, or in terms of a formula:Marginal Revenue = (Change in total revenue) divided by(Change in sales)According to the picture, people will not buy more than 100units at a price of $10.00. To sell more, price must drop.Suppose that to sell the 101st unit, the price must drop to$9.95. What will the marginal revenue of the 101st unit be? Or,in other words, by how much will total revenue increase whenthe 101st unit is sold?There is a temptation to answer this question by replying,“$9.95.” A little arithmetic shows that this answer is incorrect.Total revenue when 100 are sold is $1000. When 101 are sold,total revenue is (101) x ($9.95) = $1004.95. The marginalrevenue of the 101st unit is only $4.95.To see why the marginal revenue is less than price, one mustunderstand the importance of the downward-sloping demandcurve. To sell another unit, sellers must lower price on all units.They received an extra $9.95 for the 101st unit, but they lost$.05 on the 100 that they were previously selling. So the netincrease in revenue was the $9.95 minus the $5.00, or $4.95.There is a another way to see why marginal revenue will be lessthan price when a demand curve slopes downward. Price isaverage revenue. If the firm sells 100 for $10.00, the averagerevenue for each unit is $10.00. But as sellers sell more, theaverage revenue (or price) drops, and this can only happen if themarginal revenue is below price, pulling the average down.The reasoning of why marginal will be below average if averageis dropping can perhaps be better seen in another example.Suppose that the average age of 20 people in a room is 25 years,and that another person enters the room. If the average age ofthe people rises as a result, the extra person must be older than25. If the average age drops, the extra person must be youngerthan 25. If the added person is exactly 25, then the average agewill not change. Whenever an average is rising, its marginalmust be above the average, and whenever an average is falling,its marginal must be below the average.If one knows marginal revenue, one can tell what happens tototal revenue if sales change. If selling another unit increasestotal revenue, the marginal revenue must be greater than zero.
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If marginal revenue is less than zero, then selling another unittakes away from total revenue. If marginal revenue is zero, thanselling another does not change total revenue. This relationshipexists because marginal revenue measures the slope of the totalrevenue curve.
The picture above illustrates the relationship between totalrevenue and marginal revenue. The total revenue curve will bezero when nothing is sold and zero again when a great deal issold at a zero price. Thus, it has the shape of an inverted U. Theslope of any curve is defined as the rise over the run. The risefor the total revenue curve is the change in total revenue, andthe run is the change in output. Therefore,Slope of Total Revenue Curve = (Change in total revenue) /(Change in amount sold)But this definition of slope is identical to the definition ofmarginal revenue, which demonstrates that marginal revenue isthe slope of the total revenue curve.Next we tie marginal revenue to elasticity.
6.6 From Elasticity to Marginal Revenue(This is a moderately technical section that may trouble thosewho fear math, but it logically completes the chapter.)Marginal revenue is the extra revenue from adding another unitof output. If a firm finds that when it sells six units, itsrevenue is 24, and when it sells eight, its revenue is 28, its extrarevenue for adding two more units is four. Its marginalrevenue, or the extra revenue for adding one more unit ofproduction, will be two.
The graph above illustrates an alternative way to compute thisextra revenue. When the firm sells six, it can charge a price of $4,but when it sells eight, it can charge only $3.50. (Thus, six unitsat $4 each gives a total revenue of $24 and eight units at $3.50each gives a total revenue of $28.) When the firm sells the extratwo units, it adds two units at $3.50 each, or $7 to its revenue.However, it also loses something because it had to lower the
price on the six units it was previously selling. The loss is thesesix units times $.5 each, or $3. The net change in revenue is $7less $3, or $4. Equation (6) says that to get marginal revenue,the change in total revenue ($4) must be divided by the changein output (2), which in this example gives us $2.We have shown that marginal revenue can be computed as(Change in Q)P + (Change in P)Q) divided by (Change in Q).(This formula holds only approximately when changes are big,but becomes exact as the changes get very very small. Becausethe change in price will be negative, the second term in thenumerator will be subtracted from the first.)When changes in price and quantity are very, very small, theformula for price elasticity can be written ase = ((Change in Q)/Q) divided by ((Change in P)/P)If your algebra is fairly good, you should be able to use thesetwo formulas to show that the following equation is true:Marginal Revenue = Price (1 - 1/|elasticity|)(Verbally, this says divide one by the absolute value of elasticity.Subtract this number from one. Then, take this second numberand multiply it by price. The result is marginal revenue.)This last formula says that if demand is inelastic (less than one),trying to sell more will reduce total revenue, whereas if demandis elastic (greater than one), trying to sell more will increase totalrevenue. This should make intuitive sense. If people are notsensitive to price, then one must reduce price a great deal to sellmore, which means that total revenue declines.
Notes
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1. Case studyExplore & Apply: Demanding Better Schools, Supplying BetterSchoolsAccording to an article from the Wall Street Journal (July 1, 2003)entitled “President Bush Renews Push for School-VoucherProgram”, the President “has rarely spoken out for voucherssince Congress rejected his proposal two years ago to stripfederal funds from the worst-performing schools and makethem available to parents for private education vouchers.”However, in an address on July 1, 2003, he renewed his push bysupporting legislation for a national “school choice” incentiveplan.According to the article, Bush is supporting a bill to allocate $75million for a national “school choice” incentive plan, of which$15 million would go to the District of Columbia, largelybecause its students score lower on some standardized teststhan those anywhere else in the nation. Part of the moneyallocated to the District would go to lower-income childrenenrolled in targeted public schools. The President said he hopedthe D.C. program would become a national model for howprivate school choice can cause improvements in public schools.Critics of vouchers, including teachers unions, contend thatresearch does not show that students in voucher schools dobetter than those children who are not receiving vouchers. Theyargue that vouchers “drain money from public schools and toooften end up supporting religious schools.” Pointing toexamples from Cleveland and Milwaukee, union officials assert“vouchers subsidize a choice that parents have already made—the choice to send their child to a private school.”Thinking CriticallyApply what you have read and answer the following questions:1. Why might private-school choice make a difference in quality
education in public schools?2. What do critics say about vouchers?
2. Multiple choice questions
1 . Refer to the figure below. Which move illustrates the impactof a decrease in market price on market demand, all else thesame?
i. The move from a to b.ii. The move from a to c.
TUTORIAL 2
iii.Both moves show the same result on demand.iv. None of the above.
2 . Refer to the figure below. Assume that TVs and VCRs aretwo complement goods and that the diagram belowrepresents the demand for VCRs. Which move would bestdescribe the impact of a decrease in the price of TVs on thisdiagram?
i. The move from a to b.ii. The move from a to c.iii.Both moves. Demand first moves from a to b, then from
b to c.iv. None of the above. Since this is the demand for VCRs,
changes in the price of other goods would have noimpact on it.
3 . Refer to the figures below. Which figure shows the impact ofa decrease in income, assuming that the good in question is anormal good?
i. A.ii. B.iii. C.iv. D.
4 . In a figure of supply and demand, can you describe moreoptimistic expectations on the part of business firms in themarket?i. Yes, by shifting the supply curve to the left.ii. Yes, by shifting the supply curve to the right.
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iii. Yes, by a move from one point to another along thesupply curve.
iv. No, optimism is not a determinant of supply ordemand.
5 . Factors that quickly and directly affect the market demand fora good or service do not include:i. The price of related goods—substitutes and
complements.ii. The number of sellers, or business firms in the market.iii. The number of buyers.iv. The tastes and preferences of consumers.
6 . Which of the figures below would best describe the impactof an increase in the wages and input prices firms must payin order to produce output?
i. A.ii. B.iii. C.iv. D.
7 . Refer to the figures below. In 1973, the Arab oil embargoresulted in a severe shortage of oil in the United States, andlong lines at the gas pump. Which of the figures belowwould best describe the impact of the oil embargo on gasprices?
i. A.ii. B.iii. C.iv. D.
8 . Refer to the figures below. Which of these markets depicts asituation of high market supply relative to market demand?
i. A.ii. B.iii. C.iv. D.
9 . Refer to the figures below. In which of the markets belowdoes the good in question appear to be relatively scarcer?
i. A.ii. B.iii. C.iv. D.
10 . Refer to the figures below. When demand is high,equilibrium price is high. Choose the most applicable.
i. A.ii. B.iii. C.iv. D.
11 . Refer to the figure below. Which of the followingstatements describing this figure is entirely correct?
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i. An increase in price has shifted the supply curve, and theprice is likely to fall.
ii. After the increase in supply from S2 to S3, at a price of $8,there is an excess of quantity demanded over quantitysupplied, which will cause the market price to increase.
iii. After the shift in supply, from S2 to S3, quantitydemanded is likely to increase, arriving at a lowerequilibrium price.
iv. After the shift in supply, quantity supplied will likelyincrease along the new supply curve, and the market willlikely settle at equilibrium at a higher price and quantity.
12 . Refer to the figure below. Which of the followingstatements is correct?
i. At $8, there is excess demand after the demand curveshifts from D2 to D3.
ii. After the market settles in equilibrium, quantity suppliedwill have increased.
iii. The shift in demand will create upward pressure onprice.
iv. All of the above.13 . Refer to the figure below. Starting at point a, an increase in
demand with no change in supply moves equilibrium to:
i. Point e.ii. Point c.iii. Point h.iv. Point b.
14 . Refer to the figure below. Start at point a. A decrease inquantity demanded can be best exemplified by a move to:
i. Point g.ii. Point d.iii. Point h.iv. Point f .
15 . Refer to the figure below. An increase in demandaccompanied by a decrease in supply moves equilibrium to:
i. Point c.ii. Point i.iii. Point d.iv. Point b.
16 . Refer to the figure below. To get to point g from point a,you need:
i. A decrease in demand and an increase in supply.ii. Only a decrease in demand.iii. A decrease in demand and a decrease in supply.iv. Only a decrease in supply.
17 . If the supply and the demand for a good both rise, onething is for sure:i. Market price will increase.ii. Equilibrium quantity will increase.iii. A surplus will result.iv. Nothing. Nothing is for sure.
18 . Refer to the figure below. This figure shows that:
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i. When the magnitude of a decrease in supply is greaterthan the magnitude of an increase in demand,equilibrium price will fall, and quantity will rise.
ii. When the magnitude of an increase in supply is greaterthan the magnitude of an increase in demand,equilibrium price will fall, and quantity will rise.
iii. When supply and demand both increase, price alwaysdecreases.
iv. In equilibrium, quantity demanded is not always equalto quantity supplied.
19 . Refer to the figure below. Start at point a. This figuredemonstrates that:
i. An increase in demand alone may move equilibrium toeither point b or c.
ii. Both supply and demand must change in order to getto point d.
iii. Higher supply and higher demand result in higherprices.
iv. To get from point a to point d, there must be anincrease in supply and an increase in quantity demanded.
20 . Refer to the figure below. Assume that the government hasimposed the $8 price in this market. Which of the followingstatements is entirely correct concerning this figure?
i. $8 is a minimum imposed price.ii. $8 is a maximum imposed price.iii. $8 is too low for equilibrium, therefore, both
consumers and producers would benefit if the pricerose to equilibrium.
iv. $8 creates an excess of quantity supplied over quantitydemanded.
21 . Refer to the figure below. Assume that the government hasimposed the $8 price in this market. Which of thefollowing statements is entirely correct concerning thisfigure?
i. $8 is a price that results in a shortage, or a price aboveequilibrium price.
ii. $8 represents an imposed minimum price that creates asurplus.
iii. $8 is a price that generates an excess of quantitydemanded over quantity supplied.
iv. All of the above.22 . Refer to the figure below. According to the text, which of
the following statements is correct about the effects ofschool vouchers on the figure below?
i. Vouchers increase both the price and the quantitydemanded of private schooling.
ii. Vouchers cause the supply of private schooling to shiftto the right.
iii. Vouchers increase the demand for government-ownedpublic schools.
iv. Vouchers increase the demand for both privateschooling and public schooling.
23. Use the information on the figure below to determine theslopes of the supply and demand lines.
i. The slopes of the supply and demand lines are 1.67 and25.00 respectively.
ii. The slopes of the supply and demand lines are +6 and– 4, respectively.
iii. The slopes of the supply and demand lines are +0.166and – 0.25, respectively.
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24 . Refer to the figure below. According to the information onthe figure, the algebraic expression of the demand andsupply lines are, respectively.
i. P = 25 – 56Q and Qs = 1.67 + 0.166Qii. Q = 100 – 4P and Q = –10 + 6Piii. Q = 25 – 0.25P and Q = 1.67 + 0.166Piv. P = 25 – 0.25Q, and P = 1.67 + 0.166Q.
25.Refer to the figure below. If the government imposes amaximum price of ten dollars in this market, there will be:
i. A shortage of 10 units.ii. A surplus of 10 units.iii. A shortage of roughly 19 units.iv. A shortage of output, but there is insufficient
information to estimate how much the shortage is.
Notes
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In this chapter we go a bit deeper in the economic interpretationof consumer demand, exploring two approaches to modelingthe consumer’s choices. the older approach, in terms of“utility,” is taken first, and the more recent approach, in termsof “preferences,” follows. The “preference” approach is the oneused in more advanced economic theory and should bemastered by students who will pursue further study in econom-ics.A central idea of economics is that people make decisions byweighing costs and benefits. This idea can be stretched toexplain the amounts of goods which people buy or sell. Thekey is to see a decision about the amount to buy or sell as aseries of small decisions. To decide how much to buy, forexample, a person should consider the costs and benefits ofbuying the first item and then the costs and benefits of buyingthe second, etc. Much of economic theory is based on thissimple but vital idea.This group of readings begins by looking at goals as the sourceof benefits and constraints of scarcity as the source of costs. Itthen shows how one can arrange information obtained fromgoals and constraints so that one can make decisions based oncosts and benefits. It does this by introducing you to two rules,the maximization principle and the equimarginal principle.These rules can be derived mathematically and are in factnothing but applied calculus. They also make common sense,and these readings stress the common-sense approach to theserules.
UNIT IITHE CONSUMER MARKET
CHAPTER 3:DEMAND AND CONSUMER BEHAVIOUR
After you complete this unit, you should be able to:• Define utility, tradeoff, cost, and law of diminishing
marginal utility.• Given income and prices, be able to form a budget
constraint.• Explain what a production-possibilities frontier shows, and
what factors can move it.• If given a table of total costs or benefits, be able to compute
marginal costs and benefits, and vice versa.• When given a table or graph showing costs and benefits for
various levels of activity, use the maximization principle tofind optimum positions.
• When given an income and a table showing marginal utilitiesand prices of two items, use the equimarginal principle tofind optimum positions.
• Explain why the marginal cost curve measures the slope ofthe total cost curve.
• Interpret information on a graph showing a budgetconstraint and indifference curves.
• Define consumers’ surplus and explain how it is measuredon a demand curve.
• Define producers’ surplus and explain how it is measured ona supply curve.
• Explain the paradox of value.
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LESSON 7:CONSUMER BEHAVIOUR – I (UTILITY APPROACH)
In the previous chapter, we saw that the consumer’s demandcurve could be traced to the “marginal benefit” the person getsfrom one more unit of consumption. The “marginal benefit”is the money value of the goods the consumer would give upto get one more unit — an application of the opportunity costidea. That’s correct and adequate for the purposes of EssentialPrinciples of Economics, but not quite complete in the contextof the Rational Dialog that is the history of economic thinking.The idea of “marginal benefit” as the basis of demand has along history, and the related ideas that have been developed inthat history are important in themselves. In the earliestdevelopment of the theory of demand, economists tried to tiedemand to the one common factor that all goods and serviceshave: utility. This may seem pretty vague, but, surprisingly, wecan do a good deal with it. However, there are some criticismsof the utility approach, and many economists prefer to basedemand theory on a concept of “preference.” The “preference”theory is the one used in more advanced microeconomicscourses. This chapter I will start with the benefit & utilityapproach in turn, and in next lesson we will deal with preferenceapproach.The theory of demand is also useful in some practical applica-tions of economics known as cost-benefit analysis. In thetheory of demand, we are asking the question, “What deter-mines how much people are willing to pay for a good orservice?” In answering that question, we also learn how tomeasure the benefits consumers get from what they consume.Benefits to consumers are important for cost-benefit analysis —after all, the purpose of production is to provide benefits toconsumers, and everything else in cost-benefit analysis (and ineconomics) starts with that!The terminology and approach we will use are based on practicalcost-benefit analysis. In the long “rational dialog” of demandtheory, economists have developed two other approaches,“utility theory” and “preference theory,” each with its ownterminology, logic, and diagrams. All three approaches come tothe same practical conclusions. The later theories play importantroles in more advanced economics and the student who expectsto go on in the study of economics should understand them.They also provide insights that are important in themselves, onissues such as inflation, equity, and managing risk.
7.1 Benefit
Economists assume that people have goals and work to obtainthose goals. Economists are vague about the goals people have,though they expect that material advancement (for self orfamily) is important for most, and they say nothing at all aboutthe source of goals or their desirability. Nonetheless, theassumption that people strive to obtain their goals as best theycan, given the limitations that the world imposes on them,forms the heart of virtually all economic theory.
Goals are complex and often a bit fuzzy. Often, it is hard to seeexactly what goal a person has. For example, there are manypeople who smoke but say they want to quit. Such people are atwar with themselves. One part pulls them one way and anotherpart pulls them in an opposite direction. In addition, peopleoften do not know what it is that they want, or if they do knowwhat they want, they may not know how to obtain it. Most ofus want to be happy, but many of us are unsure what thatmeans in terms of how we should act. People spend timesearching for goals, and there are institutions, most notablyorganized religion, which try to convince people that certaingoals are more desirable than others.In the early part of this century, Frank Knight emphasized theinstability of goals. He wrote:“Wants...not only are unstable, changeable in response to allsorts of influences, but it is their essential nature to change andgrow; it is an inherent inner necessity in them. The chief thingwhich the common-sense individual actually wants is notsatisfaction for the wants which he has, but more, and betterwants.”Knight argued that “[e]conomic activity is at the same time ameans of want-satisfaction, an agency for want- and character-formation, a field of creative self-expression, and a competitivesport.”These problems of defining goals have played little role in theway economists have gone about their business, and critics ofeconomics say it is poorer as a result. Milton Friedman, one ofKnight’s students, states the way most economists proceed:“Despite these qualifications, economic theory proceeds largelyto take wants as fixed. This is primarily a case of division oflabor. The economist has little to say about the formation ofwants; this is the province of the psychologist. The economist’stask is to trace the consequences of any given set of wants. Thelegitimacy of and justification for this abstraction must restultimately, as with any other abstraction, on the light that isshed and the power to predict that is yielded by this abstrac-tion.”People will consider as a benefit anything that moves themcloser to the goal they are seeking. A businessman running abusiness will consider revenue as a benefit if his goal is to makea profit. A person striving for material advancement willconsider more belongings a benefit. A father who wants hisfamily to be happy will consider the joy of his child from a gift abenefit.But economists are not content to be this general. They want todiscuss it in mathematical terms.
7.1.1 Utility Functions
Economists like to discuss goal-seeking in a mathematicalterminology. When they talk about maximizing utility func-
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tions, they are using an abstract, mathematical way of sayingthat people are trying to attain goals. A utility function, writtenas follows:U = f(x1, x2,...xn)means that items x1, x2, etc. to some nth x all contribute to aperson’s utility. Utility, as the word is used here, is an abstractvariable, indicating goal-attainment or want-satisfaction. If aperson has simple goals or objectives, such as accumulatingmaterial possessions, then x1 may represent cars, x2 finefurniture, x3 antiques, x4 land, etc. Anything that helps achievegoals gives utility, in the jargon of economists.Though it is of no practical importance here, it should be notedthat some economists disagree with the interpretation above.They see utility as a real psychic entity, just as happiness, joy, andsatisfaction can be considered real psychic states. In thisinterpretation, the possibility of measuring utility exists,though the techniques have not been developed. If, however,utility is a fiction invented to allow us to talk about goalattainment in an abstract way, no general technique of measure-ment is possible.Economists have been reluctant to examine goals that involvecompetition for status. Perhaps their reluctance is due to theiremphasis on the mutual advantages of exchange. In an honesttransaction both the buyer and sellers must benefit or else thetransaction will not take place. However, quest for status is zero-sum. If one person rises in status, he does so at the expense ofothers who he passes up. Their reluctance to examine goalsinvolving status has meant that economists have surrenderedsome interesting questions to other disciplines. For example, towhat extent does economic development depend on the goalsthat people have? Do some goals stop economic development?Limited evidence seems to suggest that groups in which it issocially unacceptable for a person to rise relative to his neighborshave a harder time developing than those groups in which socialmobility is acceptable. Other social sciences have emphasizedpursuit of status, and it gives them a very different way ofseeing the world than the way economists do.Benefits are only part of the picture. The other part is con-straints and costs.
7.1.2 Constraints And CostsPeople have many goals that cannot be fully accomplished.Because people face constraints or limitations on theirbehavior, they must maneuver within those constraints.Constraints come in many forms. Sometimes, they are math-ematically imposed. Not everyone can be above average inintelligence, or athletic ability, or any other desirable trait. Noteveryone can be a leader—there must be followers for leaders toexist. Not everyone can win, because the concept of winnerimplies that losers must also exist.Time and biology impose the ultimate constraint on humans.A person’s life is finite, almost always lasting less than a merecentury. If one has many goals or has ambitious goals, thelimited amount of time one has to live may make manyimpossible. This means, however, that the development oftime-saving technologies, be it jet travel or packaged cake mixes,
is liberating in the sense that it makes the constraint of time lesspressing.Income and wealth are other important constraints of whichpeople are aware. Often our goals require us to make otherpeople act in certain ways. Lacking the ability to force them, onemay try to persuade them, or one may pay them. If one wantsbread from the baker or beer from the brewer, one pays them.Exchange of this sort takes place because both parties to theexchange find the exchange beneficial, i.e., it helps each sidemove toward its goals. Most people claim that their money andincome are not sufficient and that they need more, which meansthat they would like to influence the actions of many morepeople than they in fact can. Economists call this limitation thebudget constraint.Budget constraints reflect more basic constraints. People havelimited abilities and limited time in which to earn income. Inorder to earn income, people sacrifice leisure time. In general,the existence of constraints means that people faced choices,and thus costs. It means that people cannot accomplish all theirgoals (satisfy all their wants), but must choose to forgo somegoals in order to accomplish others.This point is important enough to justify spending some timewith examples. Consider the college student who wants to dowell academically, yet also wants to have an interesting andexciting social life. The basic limitation that this student faces istime. Each day has but 24 hours, and each week has but sevendays. If enough time is spent to achieve a really excellent grade-point average (GPA), say straight As, the student may have apoor or miserable social life, or a low fun-point average (FPA).If the student enjoys as high a FPA as time permits, there maybe little or no time for study, and grades may be very poor. Thisnotion of a tradeoff, that to get more of one thing, a personmust sacrifice something else, is central to the way economistsview the world.The graph below illustrates the tradeoff that the student faces.Points to the right of the line are not attainable, whereas thoseto the left of the line and points on the line are. Point arepresents a use of time with a great deal of studying and verylittle social life. Point b represents the opposite. Point crepresents a poor use of time—the student in this case may betrying to study when everyone else is socializing and trying tosocialize when most others are studying. In this case, a differentuse of time could improve both GPA and FPA.
The tradeoff line in this example is curved. This curve indicatesthat, starting from a position of no study and all fun, devotingonly a few hours to study has a big effect on GPA but reduces
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FPA only a little. Then, for each additional hour spent studyingthe increase in GPA becomes less and less and the drop in FPAbecomes greater and greater. In other words, if the student isnot studying much, an extra hour with the books will help hisGPA a lot and not cost him much in lost fun. If the student isstudying a lot already, an extra hour with the books will nothelp his GPA much, but will cost a lot in lost fun. Economistscall this pattern “decreasing returns,” and find its presence in agreat many situations.In our case of GPA versus FPA, there is neither money norprices, but there are costs. The cost of a higher GPA is the lossof FPA that must be given up. The cost of a higher FPA is theloss of GPA that must be given up. The notion of cost ineconomics refers not just to money costs, but to all options,whether measured in money or not, that must be sacrificed toget something.We next look at a budget constraint that reflects prices andmoney.
7.1.3 The Budget LineSuppose, you have only Rs.100 to spend on two passions inyour life: buying books and attending movies. If all books costRs.5.00 and all movies cost Rs.2.50 (these are simply assump-tions to make the problem easier—as is the assumption thatonly two items are involved in the problem), the graph belowshows the options open to you. The budget line is a frontiershowing what you can attain. The budget line limits choices; itis due to scarcity. The cost of a book is Rs.5.00 or two movies.Spending money on a product means that money cannot beused to purchase another product. In the case of books versusmovies, the tradeoff is a straight line because one more bookalways costs two movies, regardless of how many books youhave already.
You should be able to see that the slope of the budget linedepends only on the price of books relative to the price ofmovies. If either books get cheaper or movies get moreexpensive, the budget line in the graph above will get steeper. Ifthis is not immediately obvious, compute the possibilities opento a you with Rs.100 to spend if books and movies both costRs.5.00 (a case of more expensive movies), and the possibilitiesopen to you with Rs.100 to spend if books and movies bothcost Rs.2.50 (a case of cheaper books). Graphing the possibili-ties open to you with only Rs.50 to spend but with bookscosting Rs.5.00 and movies costing Rs.2.50 gives you a line thatis to the left of the line in the graph above, but parallel to it,which means that it has the same slope. The amount of moneyavailable to spend does not determine the slope of the budgetline; only the ratio of prices does that.
A famous example of a budget constraint is the case of gunsversus butter. During the Second World War, the United Statesdecided it needed to produce large amounts of armaments(guns). It shifted factories that previously produced goods forcivilian use (butter) to the production of guns. This tradeoffcould be represented as a move from a point such as a to apoint such as b in the graph below, except that at the start ofthe war there was still a high level of unemployment left overfrom the recessions of 1929-33 and 1937-8 (a period betterknown as the Great Depression). Hence, the United States wasnot at the limit of what it could produce, but rather at a pointsuch as c, which indicates that more of all goods could havebeen produced given the amount of resources and technology.
Though point d was a more desirable position than points a orb, it was unattainable given technology and resources. The limitto what is possible to produce is called the production-possibilities frontier. Its existence, which is a result of scarcity,indicates that there are costs to producing all goods and services.During World War II, the cost of producing thousands oftanks and jeeps was the virtual elimination of production ofautos for civilian use. The cost of feeding millions of troops inthe field was a less attractive diet for the civilian population.The major idea in this section has been that all economic activitytakes place within limitations or constraints. Because of theseconstraints, choosing results in sacrificed options. The optionsthat are not taken, which sometimes can be measured inmonetary terms, are costs.Next, we combine the utility function and budget line to getutility theory.
7.2 Utility
A choice involves deciding in favor of one option and discard-ing others. A budget constraint limits the options from whichpeople can choose. To make the best decision, a person mustchoose the option that is both possible and that contributesmost to the achievement of that person’s goals. This sectionanalyzes how people can make such choices.Though it is easy to show the budget constraint with a table orgraph, showing goals is a bit more difficult. For the purpose ofillustrating some important ideas, this section will assume thatgoal-attainment can be measured in some unit of satisfac-tion or utility. The table below gives an example by using animaginary measurement called the util.
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Benefits Measured in Utils Amount Utils from Shirts Utils from Hamburgers
1 11 8 2 20 15 3 27 21 4 31 26 5 32 30
Our second table expands the first to show utility for variouscombinations of shirts and hamburgers. Thus, one shirt andthree hamburgers give 32 utils of satisfaction (because 11 utilsfrom shirts + 21 utils from hamburgers equals 32 utils). Theperson gets the same level of satisfaction from five shirts andno hamburgers. The person whose wants are described in thistable should find these two combinations of equal value, or, toanticipate a term, he will be indifferent between them.
A Utility Function Number of Shirts .
5 32 40 47 53 58 62 4 31 39 46 52 57 61 3 27 35 42 48 53 57 2 20 28 35 41 46 50 1 11 19 26 32 37 41 0 0 8 15 21 26 30 . 0 1 2 3 4 5
. Number of Hamburgers
The consumer wants to get as much utility as possible, but abudget constraint limits him. The table above the budgetconstraint is drawn so that the person can have only five items.Looking at all combinations possible, that is, to the left of thebudget constraint (the numbers in red), one can see that thecombination three shirts and two hamburgers maximize utility.This combination yields 42 utils, and no other combinationthat is allowed by the budget constraint gives more.This simple problem can be solved in another way, with themaximization principle. The advantage of the second solutionis that it gives insight into a whole range of problems.The consumer wants to get as much utility as possible, but abudget constraint limits him. The table above the budgetconstraint is drawn so that the person can have only five items.Looking at all combinations possible, that is, to the left of thebudget constraint (the numbers in red), one can see that thecombination three shirts and two hamburgers maximize utility.This combination yields 42 utils, and no other combinationthat is allowed by the budget constraint gives more.This simple problem can be solved in another way, with themaximization principle. The advantage of the second solutionis that it gives insight into a whole range of problems.
The Maximization PrincipleOften, it is impossible or difficult to list all the options and thebudget constraint as the last section does. There can be simplerways to approach this problem. The overview suggested thatwe could break the question into a series of questions. Webegin by assuming that all money is used to buy shirts, which,in this example, means that the person buys five shirts. Then,we ask whether the person is better off buying one hamburgerthan buying none. To answer this question, we need to
compute the costs and benefits of making this change. Usingthe example from the previous section, the added benefits ofthe first hamburger is eight utils. To compute the cost ofmaking this change, we must remember the budget constraint.To get a hamburger, the person must sacrifice a shirt. Because hebegan with five, he will be left with four. As a result, the utilityhe gets from shirts will decline by one util, and this is the costof adding a hamburger. Since the change adds benefits of eightutils at a cost of one util, this is a smart change to make.
Benefits Measured in Utils (from last section) Amount Utils from Shirts Utils from Hamburgers
1 11 8 2 20 15 3 27 21 4 31 26 5 32 30
Now, we ask if another change is worthwhile. What will thecosts and benefits of adding a second hamburger be? The tablesays that the utility of two hamburgers is 15. Because eight ofthose utils come from the first hamburger, the added utility ofthe second hamburger is seven. Because the budget constraintforces the person to give up his fourth shirt in order to obtainthis hamburger, utility from shirts will drop from 31 utils to 27utils, a loss of four utils. Thus, the benefits of adding thesecond hamburger are seven utils, and the cost is a loss of fourutils. Adding the second hamburger is also a smart movebecause it increases total utility.The third hamburger is not worth obtaining. The benefit ofadding the third is six utils (moving from 15 to 21 utils in thetable). But this move requires the person to move from threeshirts to two, and in this move, seven utils from shirts are givenup. Because the cost of adding the third hamburger (sevenutils) is greater than the benefits of this hamburger (six utils),the person should not add it.Economists call the approach taken in the preceding paragraphsthe marginal approach. Thinking on the margin means that aperson is asking what the effects of small changes will be. Inthis approach one considers marginal costs and marginalbenefits. The marginal cost of a change is the change in costscaused by the change. The marginal benefit of the change is thechange in benefits caused by the change. The marginal approachsuggests that one should make all the changes that increasebenefits more than they increase costs (or that reduce costs bymore than they reduce benefits). When all these changes havebeen made, one will find oneself at a point for which marginalcosts equal marginal benefits. This rule for finding the best levelof an activity is called the maximization principle.
Costs and Benefits of Hamburgers Number of Hamburgers
Marginal Benefit of Hamburgers
Marginal Cost of Hamburgers
Total Benefit of Hamburgers
Total Cost of Hamburgers
Net Benefit
1 8 1 8 1 7 2 7 4 15 5 10 3 6 7 21 12 9 4 5 9 26 21 5 5 4 11 30 32 -2
To see that the maximization principle does generate the largestnet benefits, the problem of how many hamburgers to buy can
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be analyzed with total costs and total benefits. This analysis isillustrated in the table above. Columns two and three showmarginal costs and benefits, and the way in which they wereobtained has been described in the previous paragraphs. Totalbenefits of hamburgers are taken from the first table.Total Costs are obtained from column two of the first tableand depend on the budget constraint. The total cost of threehamburgers, for example, will be the lost utility of three shirts.Because five shirts give 32 utils, and losing three leaves only twogiving 20 utils, the total cost of three hamburgers is 12 utils.The Net Benefit column in the second table is found bysubtracting total cost from total benefit. At two hamburgers,the total utility will be ten utils higher than at the starting pointof five shirts and no hamburgers.You should see that if one has total cost one can obtainmarginal cost, and if one has total benefit one can obtainmarginal benefit, and vice versa. The formula for marginal costis:Marginal Cost = (Change in total cost)/(Change in activity)Thus, if a business knows that the total cost of producing 98shirts is Rs.398 and the total cost of producing 100 is Rs.400,the marginal cost of the 100th shirt is approximately Rs.2/2 =Rs.1.00. Notice that marginal cost is not the same as averagecost, which is found by dividing total cost by output. Alterna-tively, if one knows the marginal cost or benefit, one can findthe total cost or total benefit by adding up all the marginals.(Check the second table to see that this is so.)These results can also be shown graphically. In the picture belowthe total costs and benefits from the second table have beengraphed. The goal of the person, to maximize net benefits,requires that the person try to find the point where the totalbenefit curve is at its greatest vertical distance above the totalcost curve. (Here is one case in which the person does not wantto end up at the intersection. Can you see why?) At this point,the total cost and total benefit curves have the same slopes.Before this point, the total benefit curve is steeper, so they aremoving apart. After this point, they are moving together, whichmeans that the total cost curve has the steeper slope.
The slope of the total benefit (or cost) curve is the rise over therun, or the change in total benefit (or cost) divided by thechange in the number of hamburgers. But the marginal benefit(cost) of hamburgers is also defined as the change in totalbenefit (cost), divided by the change in the number of ham-burgers. Hence, the slope of the total benefit curve is marginalbenefit and the slope of the total cost curve is marginal cost.This idea is used to construct the marginal benefit and marginalcost curves in the bottom of the picture above. The marginalcurves are obtained by graphing the slopes of the total curves.The point at which they cross corresponds to the level ofactivity for which the slopes of the total cost and total benefitcurves are equal.We have not exhaused the insights from this simple problem.We can also analyze the numbers with the equimarginalprinciple.
7.3 The Equimarginal PrincipleAt this point, you may think we have exhausted all the insightswe can get from the hamburger-shirt problem. We have not.The table below contains columns showing the marginal utilityof shirts and the marginal utility of hamburgers. Thesemarginal utilities are obtained from our original example, whichshows the total utility of one shirt, two shirts, etc. Marginalutility is the utility of the first shirt, the second shirt, etc. Thus,the utility of the fourth hamburger is found by subtracting theutility of four hamburgers from the utility of three hamburg-ers. Notice that the marginal utility of each good declines asmore of it is used. This is a case of diminishing returns thathas the special title of “the law of diminishing marginalutility.” It is based on everyday observation and introspection.After four beers, a fifth gives less pleasure than the fourth, athird hamburger gives less satisfaction than the second, etc.
The Equimarginal Principle, or How to Spend Your Last Rupee Number Marginal Utility of Shirts Marginal Utility of Hamburgers 1 (first) 11 8
2 (second) 9 7 3 (third) 7 6 4 (fourth) 4 5 5 (fifth) 1 4
Suppose that the person is not at the optimal solution of threeshirts and two hamburgers. Suppose instead that he has twoshirts and three hamburgers. Can we tell from the table that hehas spent his money incorrectly?We can. Shirts and hamburgers cost the same. Suppose thateach costs Rs.1.00 and the person has Rs.5.00 to spend. Thenthe last Rs. spent on hamburgers gave the person only six utils,whereas the last Rs. spent on shirts gave him nine utils. The Rs.spent on shirts gave a much larger return, and if he could shiftmoney from the area in which it is giving a low return to thearea in which it has a high return, he will be better off. This isthe basic idea of the equimarginal principle. Maximizationoccurs when the return on the last Rs. spent is the same in allareas. In terms of a formula, a person wants(Marg. Benefit of A)/(Price of A) = (Marg. Benefit of B)/(Priceof B)
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The power of this idea can be shown if we change the originalproblem. Suppose that the person still has Rs.5.00 to spend,but the price of shirts doubles from Rs.1.00 to Rs.2.00. The oldsolution of three shirts and two hamburgers will no longer beaffordable but will lie to the right of the budget line. To solvethis new problem, two new columns must be added to ourtable: the marginal utility of shirts per Rs. and the marginalutility of hamburgers per Rs.. The table below adds them incolumns MUs/(Price of Shirts) (the marginal utility of shirtsdivided by the price of shirts) and MUh/Price of Hamburgers).
The Equimarginal Principle, Continued
Number Marginal Utility of Shirts
MUs Price of Shirts
Marginal Utility of Hamburgers
MUh Price of
Hamburgers 1 (first) 11 5 1/2 8 8
2 (second) 9 4 1/2 7 7 3 (third) 7 3 1/2 6 6 4 (fourth) 4 2 5 5 5 (fifth) 1 1/2 4 4
The equimarginal principle tells us to maximize utility byselecting the highest values in the columns giving marginalutility per Rupee until our budget is used up. A person withonly two Rupees should buy two hamburgers rather than oneshirt because both eight and seven are larger than five and onehalf. A person with Rs.5.00, as in our example, should buythree hamburgers and one shirt. This decision does not quiteequalize returns on the last Rupees spent on shirts andhamburgers, but it comes as close as possible. Any othercombination would give less utility and would allow for furtherimprovement. For example, if one bought two shirts and onehamburger, the extra satisfaction from a Rupee spent on shirtsis only four and one half utils, whereas shifting money tohamburgers would allow one to get seven utils per Rupee.
7.4 Diminishing Marginal UtilityThis illustrates a general principle that has much wider applica-tion in economics. In economics, we speak of a law or principleof diminishing marginal utility.The “Law of Diminishing Marginal Utility” states that for anygood or service, the marginal utility of that good or servicedecreases as the quantity of the good increases, ceterisparibus. In other words, total utility increases more andmore slowly as the quantity consumed increases.This is “diminishing returns” from the viewpoint of theconsumer, and is a general principle of economics. There mightbe a threshold before the principle applies. For example, themarginal utility of golf clubs might increase until you have afairly full set. But beyond some threshold, marginal utility willdiminish with increasing consumption of any good.As we will see, there are other applications of “diminishing(marginal) returns” in other branches of microeconomics.Here is another example of Diamond & Water, this is knownas Paradox of Diamonds and Water: The marginal utilityapproach implies that when one commodity is very common,and the other is very scarce, a person would have good reason topay more for the scarce good. The reason is that marginal utilityfor any good diminishes as the person consumes more of thegood. Thus, if a good is scarce, the average person consumes
only a little of it, and the marginal utility is (relatively) high. Ifthe good is plentiful, the average person will have more of it,and so the marginal utility will be (relatively) low.Of course, it was known that a person will pay more for a scarcegood, and that’s a matter of “common sense.” But that“common sense” fact didn’t sit well with Smith’s idea of a“natural price” — it seemed to be an exception of some sort.When economists switched to the “marginal utility” approach,the commonsense fact that people will pay more for scarcegoods no longer seemed exceptional. Instead, it is a centralpoint of the theory of demand.To make the idea clear, we need to say one more thing. Ineveryday life, marginal utility depends on the average consump-tion over a period of time. Take, for example, my marginalutility of pizza. After a couple of slices on a Thursday evening(Thursday is often pizza night) I won’t have any more pizza,usually until next week. So my average rate of pizza consump-tion is roughly two slices a week. We could say that my marginalutility of pizza fluctuates over the week, but for practicalpurposes, it makes more sense to say that my marginal utilityof pizza, per week, depends on the number of slices of pizza Ihave per week. Marginal utility in that sense determines whatI’m willing to pay for pizza.That is, if we use the marginal utility interpretation. But thereare still some problems with marginal utility thinking, ofcourse. The basic assumption was that the “Consumer isRational”. Next we see theory in practice with rational igno-rance.
7.5 Rational IgnoranceMarginalism is an application of the basic idea of calculus, andthough calculus was invented a century before Adam Smith, itwas a century after Smith when economists realized its signifi-cance. This “marginalist revolution” greatly clarified economictheory. The better understanding of their theory has promptedeconomists to search for new areas in which to use it. Weconclude this section with a visit to an area that economists haveexplored fairly recently.A person purchasing a new car usually spends time learningabout various makes of cars and shopping for prices. The moreeffort spent in these activities, the more one’s knowledge aboutcars and their prices increases. Because time is limited, andspending time searching for information means that one cannotuse that time for other purposes, there is a limit on how muchknowledge is worthwhile to gain. After some amount ofreading, talking to friends and acquaintances, and visitingautomobile dealers, a person finds that the extra benefit ofanother hour spent on these activities is less than the value ofthat hour spent in other pursuits. When one judges that thispoint has been reached, one stops searching and makes adecision.The amount of time people spend obtaining informationdiffers from product to product. They will spend less timelearning about the bicycle they give their child than they willlearning about a new car, less time deciding which brand ofsoup to buy than in deciding which house to purchase, and lesstime deciding which brand of dog food is best for Rover than
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in finding a college for their first-born. The larger the purchase,the larger the potential benefit of a few hours spent learningabout the purchase.The government has many policies that involve major sums ofmoney. For example, a major weapons system in the defensedepartment can cost Rs.50 billion. This amounts to aboutRs.200 for every person in the United States, or Rs.1000 for afamily of five. Yet few people spend much time studying thesepolicies. A reason is that to understand them requires manyhours of study, and the probability that an understanding ofthem will change them in any way is very small. Thus, for mostcitizens the benefit of learning about a program that does notdirectly affect them is small, the cost is large, and they end upnot knowing much about the program. Economists say thatthese poorly informed citizens are rationally ignorant.The phenomenon of rational ignorance is not confined topolitical affairs. There is vastly more to know than any oneperson can possibly know. To survive and prosper in the world,one must seek that knowledge which will benefit the seeker.Most people would consider someone a bit odd who was notplanning to buy a car, but went from dealer to dealer trying tolearn all he could about relative car prices in the name ofintellectual curiosity. The behavior of most citizens suggeststhat they also consider odd the seeking of in-depth knowledgeabout the pros and cons of a specific government policy if thatknowledge does not directly benefit the person who gets it. Thehypothesis of the rationally ignorant voter suggests that peoplewill be better informed about the choices they make in themarketplace than about those they make in the voting booth.A look at costs and benefits not only explains why few citizensunderstand the subtleties of most government policies, but italso explains why about one half of the eligible voters in theUnited States do not vote. The probability that one’s vote willbe the crucial vote that decides an important election is small.Even if one’s vote is the crucial vote that breaks the tie, one maynot like the outcome—many people regret the way they votedwhen they compare actual performance with campaign prom-ises. Given these small benefits compared to the costs of timeand transportation that voting entails, it is not surprising thatmany people who are eligible to vote do not. What is surprisingis that the percentage of people voting is not even smaller. Itseems likely that there are other benefits to voting that have notyet been mentioned.Politics is in many ways a spectator sport, with all the excitementand drama of football or baseball. Voting may be enjoyable inthe same way as watching and cheering on a favorite ball team.Indeed, voting against a politician one does not like is enjoy-able, even if it does not result in his defeat. Anotherexplanation for voting is that people have a sense of publicduty. They want to be good citizens, and voting may seemimportant regardless of its effect—the act of voting itself canbe important as a symbolic act. One other possibility is thatpeople may overestimate the importance of their vote and theprobability that theirs will be the ballot that decides an election.In contrast to elections in the United States, elections in the oldCommunist-bloc nations were predictable. There was no doubtabout who would win. Yet, these countries reported impressive
percentages—sometimes more than 99%, of their citizensvoted. Anyone who understands how to reason in terms ofcosts and benefits should be able to explain the implications ofvery high participation rates in meaningless elections.Keep the rationally ignorant voter in mind when interpretingpolls that ask citizens their opinions about complex publicissues. The idea that voters are rationally ignorant also hasimplications for how governments work.
7.6 Marginal Utility and DemandThe marginal utility approach resolves the “paradox ofdiamonds and water.” There is no paradox: the scarcer good,diamonds, have the higher marginal utility, even though watergives the greater total utility. This opens the way to develop atheory of demand based on utility. But we aren’t there yet.Demand is a relation between money price and quantitypurchased. So far, using our example, we have seen why aperson might give up a large amount of water to get a dia-mond. That’s not quite the same as giving up a large amountof money for a diamond. So one step we need to take is totranslate from the barter of goods for goods to the exchange ofgoods for money. Let’s check that out, in next lesson.
Notes
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This lesson applies and extends the analysis of the rationalconsumer choice. It begins by abandoning the assumption thatutility can be measured. Instead, a set of indifference curvesrepresents a person’s preferences, and that person strives to findthe point on the highest indifference curve that his budgetallows. The maximization and equimarginal principles are stillthere, but behind the scenes.We then consider some implications of budget-line andindifference-curve analysis. The simple idea that constraints hurtleads to the important concept of present value. We alsodiscover the concept of consumers’ surplus and see how thisconcept dissolves the paradox of value. Finally, we add theconcept of producers’ surplus, and see how fights over thedivision of surpluses can reduce the total.
8.1 Preference ApproachEconomists, like many other people, have been a bit skepticalabout the idea that a person’s satisfactions could be measured ina number, as the “utility” idea assumes. Twentieth-centuryeconomists have usually thought instead of “preference.”Surprisingly, perhaps, the discussion of “consumers’ prefer-ences” can get quite technical and mathematical. We will insteadtake it at an intuitive level to get the flavor of the idea.Think of a restaurant that sells barbecued chicken wings by thewing and french fries by the piece. The prices will be Rs.45 awing and Rs3 a piece of fried potatoes. (I don’t know of arestaurant that sells wings and fries this way, but it will be ok forthe example. Let’s consider some alternative menus that youcould choose: no wings, one wing, two wings, and no fries,fifteen pieces of fries, or thirty pieces of fries. Taking all possiblecombinations, we have 3x3 = 9 alternative lunches. Utilitythinking says that each combination will give you a definiteamount of utility. The preference approach says that, while yoursatisfaction from consuming wings and fries may not bemeasurable as a number, you will be able to say whether heprefers two wings and fifteen pieces of fries to one wing andthirty pieces of fries. In general, you will be able to rank thealternatives as more or less preferable. Let’s suppose yourranking of the nine alternatives looks like this: Table 8.1
wings
0 1 2 0 eighth seventh fifth
15 sixth fourth third fries
30 fourth second first
This ranking illustrates some ideas from the preference ap-proach.• First, preference is an order-ranking, not a number. This
ranking from first preference to ninth applies specifically tothese nine alternatives. If we were to consider more
LESSON 8:CONSUMER BEHAVIOUR – II PREFERENCE APPROACH
alternatives, the rankings might change, but in relative terms,they would be the same — no wings and 15 fries will alwaysbe ranked ahead of one wing and no fries.
• Second, your preferences are applied to combinations of thetwo goods. It is not that you prefer wings to fries. Rather,you prefer one wing with thirty fries to two wings withfifteen fries, and also prefers one wing with fifteen fries totwo wings with no fries. These combinations are often called“market baskets” in economics, with the idea that the basketcontains specific amounts of two or more goods.
• Third, given the amount of one good, more of the othergood is preferred to less. For example, if you have one wing,30 fries rank higher (second) than 15 (fourth). There could belimits to this, of course. If you are choosing the menu for asingle meal, he might get full and prefer less to more. But, inmore realistic examples, there will always be other goodsbeside wings and fries that you can spend your money on.So, even if you couldn’t possibly eat another wing or anotherfry, there will be some goods that he does prefer more of,rather than less. That’s good enough.
• Fourth, notice that 1 wing and 15 fries is in a tie with nowings and 30 fries for fourth place. When two alternativescome up with the same ranking, we say the consumer is“indifferent” between them, and that the two alternatives are“indifferent choices” or “indifferent alternatives.” This“indifference” relationship is not something to be“indifferent” about! It proves to be a very useful idea in thepreference approach.
8.1.1 Spending DecisionNow, let’s see how your preferences influence your spending.We’ll need to keep using Table 8.1:Suppose that you have Rs.1.35 to spend for your lunch. Youcan afford 2 wings and 15 fries or 1 wing and 30 fries (or onewing and 5 fries or one wing and no fries or no wings and 15fries). These alternatives rank third and second, so your“rational” choice is 1 wing and 30 fries. This is the choice thatyou most prefer, within your budget. By choosing it, we mightsay, you are “maximizing your preference.” That’s an awkwardphrase, but it will have to do: in the preference approach, we saythat a rational consumer maximizes her or his preferenceswithin the limit of her or his budget.It’s almost as simple as that. But, of course, there are someimportant details to keep in mind — because they help tobridge the gap between the preference approach and themarginal benefits approach
8.1.2 Relative PreferenceRemember, the preference rankings are really relative to thealternatives you are considering. If the only two alternatives are1 wing and 30 fries or two wings and 15 fries, then 1 wing and30 fries ranks first and 2 wings and 15 fries ranks second among
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those limited alternatives. What we know (and what you know)is the relative preference ranking between the two alternatives: 1wing and 30 fries is preferable 2 wings and 15 fries. Let’s seewhat happens if you are allowed to consider still more alterna-tives — he can choose 0, 1, 2, or 3 wings. We’ll show that in anew table, Table 8.2; but to make it easy for you to comparethem we will put the two tables side by side:
Table 8.1
wings 0 1 2
0 eighth seventh fifth 15 sixth fourth third fries
30 fourth second First
Table 8.2
wings 0 1 2 3
0 tenth Ninth seventh sixth 15 eighth Sixth fifth third fries
30 sixth Fourth second First
Since we have more alternatives to rank, some of the ranks aredifferent, but the relative rankings are the same. Check that: forexample, 2 wings and 15 fries ranks below 1 wing and 30 fries ineach table.But we have more information In Table 8.2. We now know that2 wings and 30 fries ranks above 3 wings and 15 fries, which wedidn’t know before.
8.1.3 Indifferent BehaviourLet’s take a closer look at Table 8.2:
wings 0 1 2 3
0 tenth ninth seventh sixth 15 eighth sixth fifth third fries
30 sixth fourth second first
Looking again, we see another tie. Now we have a three-way tie.No wings and 30 fries, 1 wing and 15 fries, and 3 wings and nofries are all tied for 6th place. These three menus, together, formwhat preference theory calls an “indifference curve” — alinking of all the combinations of goods and services thatcome up with the same ranking in a person’s preferenceranking.This “indifference” conception helps us to relate the preferenceapproach to the marginal-benefit approach. What is themarginal benefit of the first wing? We can get that by travelingalong the indifference curve corresponding to sixth place. Bydefinition, the marginal benefit is the money value of the othergoods you would give up to get that wing. Since you areindifferent between no wings and 30 fries (on the one hand)and 1 wings and 15 fries (on the other hand) we can concludethat You would give up 15 fries to get that first wing — nomore and no less. So yours marginal benefit from one wing isthe market value of 15 fries, that is, 45 cents. What is themarginal benefit of the second wing? We don’t know, exactly,from this information. We would need to try more alternativesuntil we find one that ties in rank with 1 wing and 15 fries. Butwe can approximate, using the formula MB ≅ ∆ benefits/∆wings. Notice that you would give up all 30 fries to get all 3wings. So the total benefit of 3 wings is the market value of 30fries, 90 cents. Moving from 1 wing and 15 fries to 3 wings and
no fries, we have ∆ benefits of 90-45=45 cents and wings of 2,so MB ≅45/2 = 22.5 cents. We see that you experiencesdiminishing marginal benefits of consuming wings — just aswe would think. Notice, we are still applying the good old“opportunity cost” concept. To say that you are indifferentbetween no wings and 30 fries (on the one hand) and 3 wingsand no fries (on the other hand) is to say that 30 fries is anopportunity cost you are willing to give up to get 3 wings.There is one thing we need to be cautious about. It turns outthat the marginal benefit will be different if we start out from adifferent place. For example, suppose we started out with just15 fries and no wings. We can see that you would NOT give 15fries for that first wing — that would reduce him from eighthplace in his preference ranking to ninth. So the marginal benefitof the first wing will be somewhat less than the 45 cents it waswhen you could start from 30 fries. This should not be asurprise, though. We can look at it from three points of view,and they all agree that the Marginal Benefits should depend onthe starting point. First, starting from just 15 fries, you aregoing to be hungrier, so it might make sense if he wants to fillup a little more on fries. Second, you are richer in the firstexample than in the second — starting from 30 fries is startingfrom 90 cents, while starting from 15 fries is starting from 45cents. The richer people are, the more they usually are willing topay for the goods they buy — and we are measuring benefits interms of the person’s willingness to pay. Finally, we rememberthat the marginal benefit curve is the individual demand curve.When a person’s income or wealth drops, their demand formost goods and services will decrease, and that’s what hashappened here — starting off from less income, the demandfor wings is less.
8.1.4 Key Points of Preference ApproachOf course, this example is unrealistic. The numbers are toosmall — “real men” order wings by the dozen. Much moreimportant, we have many more alternatives than we could list ina table, and we have to choose among combinations of manymore than two goods, and time plays a role, so that I canaverage my dozen wings this week with my two dozen nextweek to consume an average of 1.5 dozen a week. All the same,the example has illustrated some key points about the prefer-ence approach:• We don’t need numerical measures of utility. It is enough if
consumers can rank the alternatives they face in terms ofbetter and worse, or first, second, third and so on.
• We know that people can do that, because they do it whenthey choose among those alternatives. By choosing theyreveal their preferences.
• The alternatives are not the goods and services themselves,but different combinations of goods and services —different lunches or “market baskets.”
• The rankings have to be consistent in several ways: more ispreferred to less (perhaps up to a limit), and any two marketbaskets are ranked in the same way no matter what otheralternative market baskets are included in the ranking. Thereare some other, more technical consistency requirements thatwe will not go into now.
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• All the same, two or more market baskets can be ranked as atie. Then we say the consumer is “indifferent” betweenthem. That doesn’t mean he doesn’t care about the goodsand services — it means he will give up one of the twomarket baskets willingly in exchange for the other. This isimportant because it helps us to apply the opportunity costapproach to estimate his marginal benefits and thus hisdemand for any good or service.
Perhaps this is enough to make it clear that we really can do it —we can express an individual’s subjective benefits from consum-ing goods and services in terms of money. And that was a bigstep forward in the Reasonable Dialog of Economics.This is, of course, no more than a taste of the preferenceapproach. A good intermediate microeconomics course wouldgo into a lot more detail, with some very careful diagrams. I’llgo on with an application of preference thinking to equity inincome distribution and job assignments — a topic economistsdon’t often get into and, frankly, pretty far afield from mostother texts — and then come back with the basics of theintermediate level, diagrammatic approach to preference, whichis covered in a good many introductory texts as well. But, inEssential principles of Economics, these are all advanced topics,and you can skip out and go on to the next chapter any timewithout losing the thread.
8.2 ExamplesLets take some more examples to make the point clear:1) We consider a very small economy consisting of two persons,Grasshopper and Ant, two jobs, a hard job and an easy job, andan income that can come in two sizes: large and small. Theinstitutions of the society (the “rules of the game”) link thelarge income to the hard job and the small income to the easyjob. We suppose that Grasshopper is a bit of a lazybones.Grasshopper’s preferences among jobs and incomes is shownby Table 8.3:Table 8.3. Grasshopper’s Preferences
income large small
easy 1 2 job hard 3 4
That is, an easy job with a large income is Grasshopper’s firstpreference (naturally enough) and the easy job with a smallincome comes next, the hard job with a large income next yet,and (again naturally enough) a hard job with a small incomeranks lowest. Ant’s preferences are different and are shown byTable 8.4:Table 8.4. Ant’s Preferences
income large small
easy 1 3 job hard 2 4
At the extremes, Ant ranks the alternatives in the same naturalway as Grasshopper does, an easy job with a large income firstand a hard job with a low income last. In between, however,
Ant ranks the other two choices in the opposite way, choosing ahard job and a large income over the reverse.Now suppose that Ant is allocated the hard job, and the largeincome that comes with it, and Grasshopper is allocated theeasy job with its low income. Then Ant has his second prefer-ence, while Grasshopper’s allocation is Ant’s third preference.Ant would not choose Grasshopper’s portion over his own.Conversely, what Ant has is Grasshopper’s third preference, andGrasshopper has his own second preference, so Grasshopperwould not, either, choose Ant’s portion if he could. Since eachinsect has a job-and-income package he positively prefers over thepackage the other insect has, the allocation between the twoinsects is said to besuperfair. In general, if each insect wereindifferent between her own package and the package the otherinsect enjoys, then, in superfairness theory, the allocation wouldbe described as “fair;””when each positively prefers her ownpackage, then the allocation is “superfair.”Suppose instead that by accident Ant had been assigned the easyjob and Grasshopper the hard job. Now Grasshopper has hisown third choice, but Ant has Grasshopper’s second choice:Grasshopper “envies” Ant. Conversely, Ant has his own thirdchoice, but Grasshopper has Ant’s second choice: Ant “envies”Grasshopper. There is inequity all around. But the inequity iseasily remedied by a market transaction: given the opportunity,Ant and Grasshopper will voluntarily exchange jobs. Then bothsuperfairness and efficiency are established. In this simpleeconomy, a free market equilibrium is superfair.2) Now we consider the same small economy except for onechange: the rules will be different, and a hard job will beassociated with a small income, while an easy job has a largeincome. Perhaps that is because the easy job is highly assisted bytechnology, while the hard job is not. Anyway, in this smalleconomy there is no fair or superfair assignment of jobs. Nomatter who gets the easy, high-pay job, he has the other insect’sfirst choice, and the other insect has his own fourth choice.There is no free-market switch that will eliminate the inequity —switching jobs just changes the victim. We could say that it isthe economic system itself — the rule for assigning jobs andincomes — that is inequitable, since, with a system like that,there can never be a fair assignment of jobs.3) Now consider one more variation on the same smalleconomy. This time we will again associate the large incomewith the hard job, but there are two Ants in the population andno Grasshopper. Let’s call the two Ants Adam and Hillary. Oneof the Ants will have to be assigned the easy job/small incomebundle. Let us suppose it is Adam. Adam finds that he is stuckwith his own third preference, while Hillary has Adam’s secondpreference. Adam “envies” Hillary and the allocation betweenthem is inequitable. Switching the Ants will not help — one orthe other of them will “envy” the other. Inequity is unavoid-able in this example also.4) In the second and third example inequity cannot be avoidedin part because we have assumed that incomes come on onlytwo indivisible sizes and are rigidly associated with effortsupplies. To make the example a little less rigid, we might allowincome to be divisible, while retaining the simple assumptionthat each job requires a fixed, larger or smaller, amount of
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effort. Generalizing the first example above, we suppose that aGrasshopper will accept a hard job rather than an easy job onthe condition that the hard job pays Rs.5 more, and an Ant willaccept a hard job rather than an easy job on the condition thatthe hard job pays Rs.3 more. Let the “rules of the game” assign(by productivity?) an income of Rs.4 for an easy job and Rs.8 toa hard job. Otherwise, each of the two prefers more income toless. We have example 1 over again — the market assignmentof jobs will be superfair.5) Continuing with the preference valuations in paragraph 4, wegeneralize example 2, supposing that the “rules of the game”assign income of Rs.4 to a hard job and Rs.8 to an easy job.Once again, here is no fair or superfair assignment of jobs andincomes, since each insect must be assigned to his first or lastpreference. Suppose, however, that a benevolent economicplanner assigns Grasshopper to the easy job and Ant to thehard job, then redistributes Rs.4 of the productivity-basedincome of Grasshopper to Ant. Ant now has a hard job andRs.8 of income, while Grasshopper has an easy job and Rs.4.Ant does not prefer what Grasshopper has, net of the tax andtransfer, since Grasshopper has Rs.4 less income now; andGrasshopper does not prefer what Ant has, since Ant has ahard job and only Rs.4 more income. Redistribution of incomefrom the more productive to the less productive (but harderworking) insect has restored equity in a case in which equitywould otherwise be impossible.6) Now generalizing example 3, we again suppose that the“rules of the game” assign income of Rs.8 to a hard job andRs.4 to an easy job, but we have to allocate jobs between twoAnts. Since only one can have the high-income job, one Ant willprefer the bundle the other has to her own bundle — inequity.Now, however, our planner assigns Hillary to the easy job andAdam to the hard job, the redistributes Rs.0.50 of Adam’sincome to Hillary. Now Hillary has the easy job and Rs.4.50while Adam has the hard job and Rs.7.50. The difference in payis just Rs.3.00, which makes both Ants indifferent between thehard job and the easy job with their associated incomes. Theresult is a fair (not superfair) allocation.What examples 5) and 6) illustrate is that income redistributionmay restore equity in a situation in which equity would beimpossible without income redistribution. In some cases,market competition can lead to an equitable outcome, asexample 1) shows. In some cases, market outcomes can be veryfar off from the neoclassical concept of equity, as example 5illustrates — it was necessary in that case to redistribute half ofGrasshopper’s income to Ant to make the distribution of jobsand income equitable. In the real world, that much redistribu-tion would distort the incentives to work and produceinefficiency. One economist who has studied these issues, Dr.William Baumol, believes that the loss of production involvedwould be very great indeed. In any case, it is clear that our realeconomy does not come very close to an equitable allocation ofresources, and perhaps only limited progress in that direction ispossible.Once again, though, we can approach the study of economicequity without any numerical measures of “utility” — strictlythrough preference theory. That illustrates some of the wideapplicability of preference theory in modern economics.
8.3 Indifference CurveAs usual, we can make these ideas more general and applicableif we visualize them with a diagram. One of the best ways tovisualize a consumer’s preferences is with an “indifferencecurve” diagram.At first glance, using a graph instead of a table may not seemlike a good way to proceed. Discussion of maximizing utilitymust involve at least three variables: the amount of good A,the amount of good B, and the level of utility. Graphs haveonly two axes, and three variables seem to require a three-dimensional construction rather than a two-dimensional one.However, there is a way around this problem, one that geogra-phers use when they draw contour maps showing the threevariables of longitude, latitude, and altitude. They showaltitude with a series of lines or topographic contours such asthose in the map below, which shows a hilly section of WestVirginia.
The same method of construction can be used to show a utilitymap. A line will connect all possible combinations of good Aand good B that show the same level of utility. This line iscalled an isoutility (iso is Greek and means “the same” or“equal”) line or, more commonly, an indifference curve. Ingeneral, these isoutility lines will be curved, as in the graphbelow, if diminishing returns hold.Figure 8.1
One does not need to measure utility in order to draw a graphsuch as that in the graph above. All one needs is the ability toorder different levels of utility; that is, to say that bundle A ispreferred to bundle B, or that bundle B is preferred to bundleA, or that the chooser is indifferent between the two bundles.Indifference curves assume that individuals are consistent. IfJane prefers option A to option B, and if she also prefers
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option B to option C, then she should prefer option A tooption C. People with inconsistent behavior will not attain theirgoals as well as they could, and if behavior is too inconsistent,their behavior may show few regularities or predictable patterns.Figure 8.2 is an Indifference Curve Diagram for wings and fries,partly based on the previous numerical example. The numberof wings the person consumes is on the horizontal axis, andthe number of fries is on the vertical axis. Thus, each point inthe diagram corresponds to a particular number of wings andfries. For example, point A — with the asterisk — correspondsto 2 wings and 30 fries.
Figure 8.2: Indifference Curves for Wings and FriesAn indifference curve is a curve connecting points in thediagram in such a way that the consumer is indifferent betweenany two combinations shown by points on the curve. Forexample, consider the curve labeled II. It connects — amongothers — 30 fries and no wings, 15 fries and 1 wing, and 0 friesand 3 wings. We have already seen that these alternatives are tiedfor 6th place in the preferences, as shown in Table 8.2. Let’sassume that all the other points on curve II also correspondwith combinations of fries and wings (some in fractionalamounts) that would all be tied with these three. Then Curve IIis an indifference curve for this consumer. But it is not the onlyone, and in fact there are infinitely many indifference curvecorresponding to any consumer’s preferences.We can always draw an indifference curve through the point inthe diagram. Fractional quantities are OK. Remember, we mayget fractional quantities when we average the person’s behaviorover time — so this is an advantage. We don’t have to limitourselves to whole numbers as we do in the numerical ex-amples. If we choose two points, corresponding to twodifferent combinations of wings and fries (or any other goodsor services) either they will be on the same indifference curve oron two different indifference curves. If the same, then theperson is indifferent between the two choices. If they are ondifferent indifference curves, then one curve will be completelyabove the other, and that means the person prefers thecombination on the higher curve.Next we see how demand curves come out of indifferencecurves and budget lines.
8.4 Indifference Curve & DemandThis section takes you a bit beyond where one needs to go inintroductory economics, but it illustrates how indifferencecurves are used.
To show what the consumer should do to maximize utility, abudget line must be added to the preferences shown in theindifference curves. The picture below adds one. Point a is notattainable because it lies to the right of the budget line. Theconsumer is indifferent between points b and d because they lieon the same indifference curve, but point d is cheaper than bbecause d lies below the budget line. The consumer wants toget on the highest indifference curve affordable, and this willlead him to point c.Figure 8.2
The effect of a rise in the price of good A is shown on thegraph below. A higher price of A means that less of A can bepurchased, and hence the budget line moves to the left,intersecting the vertical axis at a lower point. Point c is no longerpossible and the consumer must move to a new position,which, assuming utility maximization, will be point b. Unlessthe indifference curves are peculiar, point b will represent less ofgood A than will point c, which is what the law of demandsays will happen.Figure 8.3
Looking at two different prices has produced two differentpoints on an individual’s demand curve. By varying the price ofgood A, other points could be found and an entire demandcurve for one individual consumer constructed. The marketdemand curve is obtained by adding up the demand curves ofall individuals.
8.5 Marginal Rate of SubstitutionLet’s step back and think about an indifference curve in a littlemore detail. Looking at Figure 4, below, we see that indifferencecurve II gets flatter and flatter as we move down it from the leftto the right. The other indifference curves are similar — typically,the slope of an indifference curve changes, becoming flatter aswe move from left to right.
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Figure 8.4 : The Slope of an Indifference Curve
What is this telling us? At 1 wing and 15 fries, the slope of theindifference curve is 10 — that is, moving down the indifferencecurve, a reduction of one fry has to be compensated with 0.1wing, in order to keep the consumer on the same indifferencecurve. (Remember, the scales on the two axes are different). Aslong as he is on the same indifference curve, the consumer is atthe same level in his preference ranking — no better and noworse off. Putting it another way, the consumer is willing togive up one fry to get another tenth of a wing (since theexchange leaves him no better and no worse off). The slope ofthe indifference curve tells us something very important — howmuch of one good a person is willing to give up to get onemore unit of the other good.Economists have a term for the slope of an indifference curve.The term is the “marginal rate of substitution.” What wehave just seen is that, at 1 wing and 15 fries, the slope of theindifference curve is 10 — meaning the consumer would giveup only one-tenth of a wing to get one more fry. To summa-rize:
Definition: The Marginal Rate of SubstitutionThe marginal rate of substitution between two goods is(minus) the slope of an indifference curve for the two goods.
InterpretationThe marginal rate of substitution tells us how much of onegood a person will give up to get one more unit of the othergood.We have also seen that the marginal rate of substitution variesin a specific way. As the consumer has more of a good (movingfrom left to right) the marginal rate of substitution decreases(the slope gets flatter). This “law” of decreasing marginal rateof substitution brings to mind the “laws” of diminishingmarginal benefit and marginal utility. Indeed, it is the same lawin another form.
8.6 Income & Substitution EffectLets take an example of Potatoes as a Giffen Good, i.e. lowpriced – low quality product. Consumers are much better offwith the lower price of potatoes that they buy more of otherfoods, and thus less of the inferior good, potatoes. Can we putthis explanation to the test? Turning it around, the explanationsays that, if people could buy potatoes at the lower price, butsomehow they were no better off, then they would buy morepotatoes, not less. (If it is being better off that reverses the law
of demand, then we should see the law of demand back in fullforce if they were no better off).With a lower price and the same money income, people arebetter off, in this example. But if the lower price were offset bya lower income, they would be no better off. There is a certainreduction of income that would leave the person neither betteroff nor worse of than before, even though the price is lower.That reduction in income is called the “compensating incomevariation” for the price drop. This is shown in Figure 5. Tofigure out the compensating income variation in the diagram,we just move the budget line N (for the new, low price) downto N’, which just touches indifference curve I. Since theconsumer is back on indifference curve I, she is no better offnor worse off than before — in terms of her own preferences.With budget line N’, we see that the consumer will buy quantityC of potatoes — more potatoes at the lower price. What we seeis that the cut in price has increased the quantity demandedfrom A to C, but the increase in the purchasing power ofincome has cut the consumption of potatoes all the way fromC back to B. So the testimony holds up — it seems that aGiffen good could be a reality in terms of preference theory.
Figure 5: Income and Substitution Effect
8.7 Concluding SummaryThe Reasonable Dialog on the theory of demand began withthe idea that willingness to pay for a good or service might berelated to the utility derived from the good or service — andquickly rejected it, since that idea seemed to be undercut by the“Paradox of Diamonds and Water.” However, the alternativeapproach (the Labor Theory of Value) had its own problems,and nearly 100 years later, economists reconsidered the issue.Using the marginal approach — for the first time — econo-mists of the 1870’s realized that willingness to pay for one unitof a good or service would depend on the marginal utility, notthe total utility. In the light of that understanding, the paradoxwas not a paradox at all. The marginal approach undercut theparadox, and restored the credibility of the utility approach. A“new economics” of consumer demand was created on thebasis of marginal utility.But there were other problems with the utility approach. Noteveryone could accept the idea of direct numerical measurementof consumer satisfaction. What are the units? Are they the samefor different people, or different, and if they are different for
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different people, how can that be considered measurement?Some of the critics proposed an alternaThe theory of consumer choice that the indifference curvesembody is an elegant construction with which economistsframe problems. One of its weaknesses is that a great manyoutcomes are consistent with it—though a downward-slopingdemand curve can be derived from it, so too can an upwardsloping demand curve. Further, in recent years there has been arealization among economists that pictures such as those abovemay not be a good description of the decision-making processwhen people must make decisions with partial information,with fuzzy goals, under conditions of risk and uncertainty, andwhen options are difficult to compare. Finally, there do seem tobe cases in which people systematically violate the rules that thistheory says are rational.
Notes
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9.1 Indifference Curve Analysis1. We can begin by examining the two good, single consumercase. Each consumer starts with a budget constraint, represent-ing how one’s income is spent on a set of goods and services.We’ll assume that there are only two goods to consider in thetypical consumer budget and that all of this consumer’s incomeis spent on these goods.The Budget Constraint is:I = P1Q1 + P2Q2
(where I = income, P = price, Q = quantity for goods 1 and 2)We can take this equation, rearrange it to get:Q1 = -(P2/P1)(Q2) + (I/P1)What can we say about the rearranged budget constraintequation? First, we may notice that this rearranged budgetconstraint is an equation for a line (with a negative slope P2/P1
and vertical intercept I/P1). Intuitively, we may recognize thatthe ratio of prices represents a comparison of the cost toconsumers of one unit of each good. Therefore, in a sense, wecan say that P2/P1 is the ratio of the marginal cost of goods 1and 2 respectively. Recalling our macroeconomic discussion ofprice indexes, we see that I/P1 is a measure of our good 1purchasing power (i.e. how much of good 1 our income canbuy). If P1 falls, I/P1 gets bigger - which means that we can buymore of good 1.2. While the budget constraint represents how much a con-sumer is able to spend, we also need to know how much aconsumer wants to spend on each good. That is, we need someinformation about this consumer’s preferences regarding eachgood.This information is found in an indifference curve. Indifferencecurves are drawn with two basic ideas in mind: (a) within certainlimits, consumers always prefer more of everything to less (e.g.I’d prefer receiving 3 boxes of Cocoa Puffs and 2 boxes ofHoneycomb to 2 and 1 box respectively); and (b) it is possibleto derive the same satisfaction out of a variety of potentialpurchase combinations (e.g. when considering a potential cerealpurchase, a consumer may be indifferent between buying 3boxes of Cocoa Puffs and 2 boxes of Honeycomb versus 2 and3 boxes respectively).Therefore, by considering one’s preferences, we see thatconsumers make purchasing decisions which depend upon thesatisfaction (more formally, the utility) derived from a particulargood. Each unit consumed (e.g. each box of cereal) in a giventime period yields some sort of satisfaction. When we examinethe amount of satisfaction derived from each unit consumed,we are considering something called marginal utility (MU). Theslope of the indifference curve may be expressed as a ratio ofthe marginal utilities associated with each good (MU2/MU1).Rather than write this ratio, however, we can simplify things by
LESSON 9:CONSUMER BEHAVIOUR – III INDIFFERENCE CURVE
calling it the marginal rate of substitution between goods 1 and2 (MRS).Where does equilibrium occur? Equilibrium occurs where theslopes of the indifference curve and budget constraint are equal.Mathematically, this occurs where MRS = P2/P1. This is anequilibrium point because at this point there is no reason tomove away. The marginal rate of substitution can also bethought of as a ratio of marginal benefit that each goodprovides our consumer. Therefore, equilibrium in this settinginvolves equating the marginal benefit for two goods with theirmarginal cost. In simpler terms, we’re saying that our consumeris getting out of each good exactly what they’re worth.We can demonstrate equilibrium graphically as well (see thegraph below). Consider two different indifference curves: IC(the red curve) and IC’ (the blue curve). Every point on IC (andIC’) represents a different potential purchase of goods 1 and 2.As mentioned above, on each indifference curve our consumeris indifferent about purchasing any of the potential combina-tions along that curve. Consequently, along a particular curve,the only difference between each point is the amount of goods1 and 2 that are purchased. The consumer is just as satisfiedwith any of the points on a given curve. Two things willdetermine which point gets selected: the consumer’s income andthe price of each good.
To find out where the equilibrium is, if one exists, we want tosee if there is one point that is always prefered to every otherpoint. We can begin by starting at a specific point (the one wepick isn’t important). To keep things simple, we’ll continue toassume that our consumer spends their entire income on thesetwo goods. Start at point B, at the top of the Budget Con-straint. Based on our discussion above, we know that points Aand B provide this consumer with equal levels of satisfaction.That is, the consumer is indifferent between points A and B.Although this consumer is indifferent between points A and B,this is not the case with points A and C. Point C is clearly betterthan point A for one important reason. At point C, ourconsumer gets more of both goods. As mentioned above, thebasic idea behind these indifference curves (where each good’sMU is greater than zero) is that “more is better”. Whencomparing two points, like A and C, this is always true. When
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you get more of one good but less of the other, it may be truebut not necessarily so (e.g. our consumer is not better off whenmoving from A to B).Thus far we know that our consumer is indifferent between Aand B, but prefers C to A. Therefore, logic dictates that ourconsumer must also prefer C to B. No matter which point westart with, our result would be the same. In the end we realizethat, if “all roads lead to point C”, point C must be theequilibrium.
9.2 Indifference Curves and the ConsumerEquilibriumLet’s assume that a representative consumer named HomerSimpson consumes beer and pork rinds in varying amounts.Assume further that the overall utility he derives from consum-ing these goods can be described by the utility function below.Note that this is just one possible example of a utility function,that there are many other possible functions we could have usedinstead.
RBR)U(B,(1) ⋅=
We can use this utility function to derive Homer’s indifferencecurve. By setting (1) equal to a specific number, we are sayingthat there are various combinations of B and R that yield a levelof utility equal to that specific number. For example, supposewe set Homer’s utility function equal to 100. We derive theindifference curve allowing 100 units of utility (i.e. utils) byrearranging the equation as
100RB(1a) =⋅
Now, solve (1a) for B by squaring both sides to get:1(b) B.R = 10,000
Second, we divide both sides of (1b) by the variable R.1(c) B = 10,000/R
This is the equation for one indifference curve. As stated above,(1c) tells us the various combinations of beer and pork rindsthat will provide Homer with 100 utils of satisfaction.For example, if Homer consumes 10 units of beer, he needs toconsume 1,000 units of pork rinds to get 100 utils of satisfac-tion. Of course, this equation also tells us that Homer wouldbe indifferent between consuming that bundle of goods (10units of beer and 1,000 units of pork rinds) and another onewith 100 units of beer and 100 units of pork rinds. This isbecause both bundles provide 100 utils of satisfaction.The graph that goes with (1c) is pictured below. The twodifferent consumption points we just discussed are pictured too(with their coordinates reported as (R,B)). Both are on theindifference curve, both yield 100 utils of satisfaction.
Not knowing whether Homer will actually consume at either ofthese points, or whether he’ll even consume on this indifferencecurve, we turn now to figuring out where Homer’s consump-tion will actually occur. To do this we need a couple pieces ofmissing information: (a) the slope of the indifference curve,and (b) the budget constraint equation.In a model where we examine two goods simultaneously, theslope of the indifference curve is going to be the marginal utilityrelated to consuming more of one good divided by themarginal utility related to consuming less of the other good.While the utility along any indifference curve is constant, themarginal utility is not.The marginal utility (MU) for each good above is given as:
B2R
MUB =
R2B
MUR =
The slope of the indifference curve, called the marginal rate ofsubstitution, will be MUR/MUB. Note that the slope of thiscurve is negative (to see this mathematically, consider (1c)),which means we write the marginal rate of substitution forpork rinds and beer (MRSR,B) as:(2) MRSS,B = –B/RWe’ll assume that the price of beer is $4 and that the price ofpork rinds is $2. Assume further that Homer’s income is $200.The budget constraint is then given as:(3) 4B+2R = 200Rearranging (3), by solving for B, we get the following (rear-ranged budget constraint):(3a) B = –0.5R+50Noting that (3a) is the equation of a line (slope of –0.5, verticalintercept of 50), we can graph the indifference curve and budgetconstraint together. Equilibrium is attained where the (blue)indifference curve is tangent to the (red) budget constraint. Thispoint is included in the graph.
The graph enables us to visually determine equilibrium, butalso note the two conditions which must simultaneously occurwhen we are at this equilibrium point. Those conditions are:• the slope of the budget constraint must equal the slope of
the indifference curve (i.e. MRSR,B = -PR/PB)• our consumer must be on their budget constraint (i.e. 4B +
2R = 200)
R*
B*
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With this in mind, we can now solve for equilibrium here.Substitute the values of the slopes into the first condition.(4) –B/R = –0.5Solve (4) for B.(4a) B = 0.5RSubstitute (4a) into the budget constraint (for B).(5) 4(0.5R) + 2R = 200Solve (5) for R. This is the equilibrium value for R (i.e. R*).R* = 50Plug R* into the original budget constraint (or (4)), and solvefor B. This is the equilibrium value for B (i.e. B*).4B + 2(50) = 200B* = 25Given Homer’s budget constraint and utility function, Homershould consume 25 units of beer and 50 units of pork rinds.If he does this, then his overall utility will be:
2255025 =⋅
That is, Homer will experience about 35.4 utils of satisfactionfrom his 25 units of beer and 50 units of pork rinds.
9.3 Utility Max Application of the Implicit FunctionTheorem
Assume that a consumer named Homer Simpson consumesvarying amounts of Duff beer and pork rindsLet:• units of beer consumed = B• units of pork rinds consumed = RHomer derives his utility from consuming these goods inaccordance with the following utility function (where U =utility):(1) U = f(B,R)Homer’s purchasing decision is limited by the following budgetconstraint (where p i is the price of good i, and I is Homer’sincome):(2) PBB + PRR = INote that (2) can be rearranged to become:
RR
B
PI
PPR(2a) +−=
Utility maximization leads us to the following equilibriumcondition (which says that the slope of the indifference curveequals the slope of the budget constraint):
R
B
R
B
PP
MUMU
(3) =
(where MUi = marginal utility of good i; which equals thederivative of the utility function with respect to good i)Let us first take the total derivative of (1), the utility function.Upon doing so, we have:
dkdRR
R)U(B,dBB
R)U(B,(4) =∂
∂+∂
∂
(where k is a constant equal to some overall level of utility, suchthat k³ 0)Dividing both sides of (4) by dB yields:
dBdk
dBdR
RR)U(B,
dBdB
BR)U(B,(5) =⋅
∂∂+⋅
∂∂
Because dB/dB = 1, and dk/dB = 0, we can simplify (5) to get:
0dBdR
RR)U(B,
BR)U(B,
(5a) =⋅∂
∂+
∂∂
Solving (5a) for dR/dB yields:
∂∂
∂∂
−=
RR)U(B,
BR)U(B,
dBdR
(5a)
At this point, we need to stop and ask what we’ve got thus far.In doing so, let’s recall a couple of points made above. First, wenote that the marginal utility of good i can be expressed as thefirst derivative of the utility function taken with respect to goodi. Second, we note that an indifference curve’s slope is equal (inthe two-good case) to the ratio of the marginal utilities.Because the righthand side of (6) involves the ratio of twoderivatives of the utility function (each taken with respect to oneof the goods consumed by Homer), the righthand side of (6)must be the slope of Homer’s indifference curve. If the slopeof Homer’s indifference curve was set equal to the slope of hisbudget constraint, then we would have the consumer equilib-rium expression given in (3).To take the actual derivatives just mentioned, however, we needto assume a functional form for the utility function in (1). Let’sassume a linear (additive) utility function for this example, thefunction given below (where q is a parameter that’s greater thanzero, a is a parameter that’s between 0 and 1, and ln(i) = naturallog of good i):
(R)lna)(1(B)lna?U(1a) −++=
If we take the derivatives described in (6) and substitute thosederivatives into (3), then we have (recall that if y = ln(x), thendy/dx = 1/x):
R
B
PP
Ra)(1
Ba
(7) −=
−
−
The two equations which describe the tangency point betweenHomer’s indifference curve and his budget constraint are (7) and(2a). Using these equations together, we can solve for B* andR*. In their present form, those solutions are:
R
B
PIa)(aR*
PaIB*
−=
=
If we wish to go further and assume numerical values for theparameters in this model, then we could assume the following:
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α = 0.5 pB = $4
θ = 100 pR = $2 I = $200Substituting into our solution above, the numerical values forB* and R* are:B* = 25R* = 50These are the amounts of beer and pork rinds that will giveHomer his maximum utility.
9.4 Substitution and Income Effects in theIndifference Curve model
Homer Simpson, our representative consumer, consumesvarying amounts of beer and pork rinds. Assume that B =quantity of beer consumed, and that R = quantity of porkrinds consumed. Homer’s utility function is givenas: RB)R,B(U ⋅= .The marginal rate of substitution (which is the slope ofHomer’s indifference curve) between beer and pork rinds isgiven in absolute value as: R
BMRS B,R −= . Recall that this can bederived from Homer’s utility function. If we use a differentutility function, then we get a different MRSR,B.Assume further that the price of beer is $4, the price of porkrinds is $2, and that Homer’s income is $200. We can obtainHomer’s budget constraint from this information, which wecan rearrange as: B = -0.5R + 50.A consumer equilibrium occurs in the graph below at pt. X1,where the (blue) indifference curve is tangent to the (red)budget constraint.
B
R
X1
It is possible to calculate the quantities of beer and pork rinds atthis consumer equilibrium. After doing so, we would find thatB* = 25 units and R* = 50 units.How is the graph above affected when the price of pork rinds increasesfrom $2 to $4? This change is shown on the graph below. Thebudget constraint becomes steeper and Homer moves to a new(pink) indifference curve and a lower level of utility at pt. X2. Ifwe calculate the new consumer equilibrium at pt. X2, we wouldget B* = 25 and R* = 25.
B
R
X1X 2
Notice, however, that the price change included two actions.The movement from pt. X1 to pt. X2 involved a change in themarginal rate of substitution (i.e. a change in the slope of theindifference curve), and a change in utility (i.e. a change from theblue indifference curve to the pink indifference curve). This isdifferent from a change in income, which only involves onechange – a change in utility. These two actions form theanalytical basis for what we call the substitution effect and theincome effect.
9.4.1 The Substitution and Income EffectsWhen prices rise, consumers lose purchasing power. What ifthe price of pork rinds goes up, but the government offers tocompensate Homer for this loss of purchasing power. That is,Mayor Quimby offers to mail Homer a check, in an effort tokeep Homer from feeling worse off. Homer still faces thehigher pork rinds price, but doesn’t experience a change inutility. That is, for Homer to be no worse off after the priceincrease, the government check must be large enough to keepHomer on his original indifference curve.If the government check allows Homer to remain on hisoriginal indifference curve, will he just return to pt. X1 and goback to buying 50 units of pork rinds? No. Even thoughHomer would return to his original indifference curve, hewould also still face a different pair of prices. Therefore, weknow that Homer must be located at a different point on thatoriginal indifference curve.By taking the second graph above, and drawing a “hypotheticalbudget constraint”, we can find this new point. This newconstraint must satisfy two criteria. First, the constraint mustbe parallel to the new prices (where beer and pork rinds eachcost $4). Second, the constraint must be tangent to the originalindifference curve.The dotted line in the graph below satisfies these criteria, and sorepresents this new constraint. This line is tangent to Homer’soriginal indifference curve at pt. W. This point reveals thequantities of beer and pork rinds that Homer would buy afterreceiving his government check (the check that keeps his utilityconstant). Of course, in real life, Homer would never get acheck from the Mayor, but we will use pt. W to distinguishbetween the two actions (or effects) we noted as occuring withevery price change.
B
R
X1X2
W
How much would Homer consume at pt. W? The calculation issomewhat involved. First, note that the slope of Homer’s newconstraint is -1. Consequently, at pt. W, the slope of his original
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indifference curve equals -1. If R/B = 1 at pt. W, then B = R atpt. W also. That is, we can ascertain that Homer will buy anequal amount of beer and pork rinds at pt. W.Homer’s original level of utility is 225 (i.e. plug the originalconsumer equilibrium valuesof B = 25 and R = 50 into Homer’s utility function). Tomaintain Homer’s original level of utility, then 225RB =⋅ .That is, Homer will buy some combination of B and R thatmakes his utility function equal to . Recall that, at pt. W, Homerwill buy an equal amount of beer and pork rinds. Therefore,we can rewrite as , which simplifies to . If , and B* = R*, then .The new (hypothetical) budget constraint would be given as 4B+ 4R = 200 + DI, where DI is the change in income necessaryto keep Homer’s utility constant. Plugging in B* and R* fromthe paragraph above, we find that DI = $82.84. That is, ifHomer receives a check for $82.84, then Homer can continue toreceive his original level of utility (i.e. utils) even though porkrinds are $2 more expensive now.What are the substitution and income effects? The two effects areseparated by pt. W. As the quantity of pork rinds changesbetween pt. W and pt. X1 we observe the substitution effect.At pt. X1, Homer consumes 50 units of pork rinds. At pt. W,Homer consumes 225 units of pork rinds (i.e. about 35.36units). The substitution effect associated with this price increaseis represented by a decrease in quantity. That is, the substitutioneffect reveals a negative relationship between the price andquantity change. In fact, with every price change, we find thisnegative relationship within the substitution effect.The income effect is measured as the quantity change attributedto moving from pt. W to pt. X2. Between these two points,only utility changes, there is no change in the slope of thebudget constraint. At pt. X2, Homer consumes 25 units ofpork rinds. The difference between pts. W and X2 becomes
25225 − , about 10.36 units.Note that, like the substitution effect, there is a decrease inquantity within the income effect. Unlike the substitutioneffect, however, a negative relationship between price andquantity does not always arise within the income effect. Fornormal goods, the income effect reveals a negative relationshipbetween price and quantity changes. That is, price increases leadto the income effect involving a decrease in quantity, and pricedecreases lead to the income effect involving an increase inquantity. Obviously, Homer considers pork rinds to be anormal good.For inferior goods, we get the opposite result – the incomeeffect involves a positive relationship between price and quantitychanges. Any increase in price (decrease) would lead to theincome effect yielding an increase in quantity (decrease).Suppose the inferior good is highly inferior. For example,suppose we have a good where any small increase in price leadsto a large, positive income effect. This would explain why afairly large price change leads to an insignificant (overall) changein quantity. The inferior good’s large income effect moves in theopposite direction of the substitution effect, causing the overallchange (i.e. the sum of the two effects) to be very small.
In some cases, if a good is inferior enough, the positive incomeeffect may be so large that it leads to price increases (decreases)being accompanied by overall quantity increases (decreases).When this occurs, we are dealing with a special (and rare) type ofgood known as a Giffen good. Giffen goods are so inferiorthat the income effect overwhelms the substitution effect,leading to the perverse result described above – where there isan overall positive relationship between price and quantitychanges.
9.5 Application of Indifference Curves: Lump Sumvs. Per Unit Taxes
Assume we have a new representative consumer, MargeSimpson, who derives different levels of utility from buyingvarying quantities of beer and pork rinds (QB = quantity ofbeer, QR = quantity of pork rinds).Her utility can be calculated from the following utility function:
RB QQU ⋅=
This utility function implies that her indifference curves, IC,have a slope that is nonlinear. That slope, called the marginalrate of substitution between beer and pork rinds, can becalculated by plugging different quantities into the equationbelow:
B
RR,B Q
QMRS −=
Let’s assume further that Marge faces the following prices andthat she has the income given below as well.Price of beer = $4Price of pork rinds = $2Income = $200We can start our analysis by asking this question:How many units of beer and pork rinds should Marge buy?We know, from previous work/handouts, that there are twoequations which will help us determine the answer to ourquestion. Furthermore, we know that both must be truesimultaneously. Those equations are:(1) 4QB + 2QR = 200 (Marge must be somewhere on her
budget constraint, BC)(2) - 4/2 = - QR/QB (the slope of Marge’s BC must
equal MRSB,R at equilibrium)Solving (1) and (2) simultaneously (e.g. using algebraic substitu-tion), we find that Marge will buy 25 units of beer and 50 unitsof pork rinds. Her indifference curve graph appears as:
QR
QB
50
25
IC1
Let’s assume that the government is considering two differenttypes of tax. The first tax is a per unit tax. That is, a tax that is
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levied on the number of units of a specific good that arepurchased by Marge. The second tax is a lump sum tax. Thatis, a tax of some fixed amount that does not correspond withthe number of units Marge decides to buy of either good.Suppose that a $1 per unit tax is levied on beer. This changesthe actual price that Marge pays for each unit of beer. For eachunit of beer that she purchases, she pays the sum of theequilibrium price and tax on that unit. For example, if the priceis $4 per unit and the tax is $1 per unit sold, then Marge will pay$5 for each unit she buys. That changes the budget constraintequation (above) and, of course, the slope of the budgetconstraint as follows:(1a) 5QB + 2QR = 200(2a) - 5/2 = - QR/QB
Again, solving (1a) and (2a) simultaneously, we find that Margewill buy 20 units of beer and 50 units of pork rinds. Thebudget constraint shifts inward, and she moves to a new, lowerindifference curve as follows:
QR
QB
50
20
IC1
IC2
25
We note that, with this per unit tax on beer in place, thegovernment will raise $20 in tax revenue from Marge (i.e. Margepays $1 tax for each of the 20 units she buys).If the government decides to go with the lump sum tax, thenMarge (and all other consumers) must pay (instead) a specificlump sum amount. It seems safe to assume that if thegovernment raises the same amount of tax revenue from Margewith either tax, then the government will not have a preferenceas to which tax is used.An important second question, however, is whether Marge hasa preference. To answer this question, let’s assume that thegovernment levies a lump sum tax of $20 on Marge (equal tothe amount she’d pay with the per unit tax).The new lump sum tax would reduce her Marge’s income by$20, but, unlike the per unit tax, will leave the price of beerunchanged. With her new, lower post-tax income ($180,instead of $200), Marge faces a new budget constraint. Thebudget constraint doesn’t change in slope, but does shiftinward because of a change in each intercept. This is reflected inthe following equations:(1b) 4QB + 2QR = 180(2b) - 4/2 = - QR/QB
Again, solving (1b) and (2b) simultaneously, we find that Margewill buy 22.5 units of beer and 45 units of pork rinds. On agraph, we see the budget constraint shift in parallel as Margemoves to a new, lower indifference curve (IC3):
QR
QB
45
22.5
IC1
IC3
The most straightforward method for determining whetherMarge prefers one tax over the other is to calculate her utility inboth situations. To do so, we utilize the utility function givenat the beginning of this handout and then compare the utilityassociated with the per unit tax case and the lump sum tax caseby plugging in the appropriate equilibrium values for QB and QR
as follows:Per unit tax: 62.315020U =⋅=
Lump Sum tax: 82.31455.22U =⋅=
Marge’s utility is higher when the government raises $20 in taxrevenue from a lump sum tax than when the government raises$20 from a per unit tax.Why do we get this result? In other material, we’ve noted thatprice changes have a dual effect on a consumer’s purchasingdecision. There is both a change in relative prices, called thesubstitution effect, and a purchasing power change, called theincome effect. When income changes, there is only one effect –the income effect. The per unit tax is comparable to a pricechange and so consumers react more with this tax than with thelump sum tax - when there is only a change in income. Thedifference in utility between these two cases represents a type ofutility loss for Marge. Because deadweight loss arises whenconsumers substitute their consumption away from a particulargood, the lump sum tax is thought to be more efficient,because the lump sum tax does not induce this kind ofbehavior (i.e. there is no substitution effect with a lump sumtax).
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LESSON 10:CONSUMER BEHAVIOUR – IV
PRICE EFFECT AND CONSUMER SURPLUS
In previous lesson you read the preference approach with theassumption of ‘Rationality’. Now in this lesson I will move astep ahead and take up some cases of violations of assumptionof ‘Rationality’.
9.1 Quasi RationalityImagine that you purchased a ticket to a concert given by yourfavorite musical group. On the evening of the concert, ablizzard makes travel extremely hazardous. Would you go?Now imagine that you had been given this same ticket. Wouldyou be more or less likely to travel to the concert in this casethan in the previous case?Or, suppose that you were given Rs.200 and these two options:A) a sure gain of Rs.50 or B) a 25% chance of winning Rs.200and a 75% chance of winning nothing. Which would youchoose? Now, suppose that you were given Rs.400 and thesetwo options: C) a sure loss of Rs.150 or D) a 3/4 chance oflosing Rs.200 and a 1/4 chance of losing nothing? Whichwould you choose? 1
If you are like most people, you would be less likely to go tothe concert if the ticket were given to you. However, thisresponse is, according to the logic of economics, irrational. Ifyou are like most people, you will choose A over B and D overC in the second example. Again, this is an irrational response.Examples such as these suggest that we should be cautious inassuming that people are rational calculating machines. There arecases in which people deviate from the behavior that the simplecalculus of utility maximization says they should follow, andthese deviations are predictable. The term “quasi-rational” hasbeen given to them.When given the concert example, many people find it difficultto believe that it should make no difference how one obtainsthe ticket.2 The easiest way to see the logic of economics is toask what determines the value of the ticket. Is it the cost of theticket or is it the value of the concert? If it is the value of theconcert (the economist’s answer), it should be obvious that youshould be equally likely to go in either case. If you want to say itis the cost, what is the value of a forged ticket that you bought?Does it have value because you spent money on it, even if it willnot get you admitted to the concert?If you analyze the second case above, you will see that situationA and C are identical, as are B and D. In A or C, one is offered asure gain of Rs.250; and in B or D, one is offered a 25% chanceof Rs.400 and a 75% chance of Rs.200. Yet the way of framingthe question seems to trick the human mind into seeing theseoptions in very different ways.The economists and psychologists studying these anomalieshave suggested that our mental abilities cannot process theeconomic information in our lives as the abstract logic ofconsumer choice says we should, and in order to deal with it, wedevelop mental accounting systems. Sometimes, these
systems are more than mental, as when families have separatesavings accounts for various items. They will often borrowmoney rather than dip into one of these special accounts,though a calculating-machine mind would never do that.One feature of most mental accounting systems is that theystart from a fixed point, usually the status quo. Changes codedas losses seem to have a greater emotional impact than changescoded as gains. As a result, if a situation is seen as an actual lossrather than as a gain not taken, it has a greater impact on peoplethan if it is seen in the other way. However, economic theorysays an actual loss and a gain not taken are equivalent.3
If we can be fooled by the way situations are framed, peopleselling things to us should be smart enough to take advantageof this computational defect. There are a number of situationsin which this seems to happen.We are more pleased with many small gains than one big gainof equal magnitude—we would rather get our Christmaspresents in lots of boxes rather than one big one. There areinnumerable sales pitches that promise something free if andonly if we buy a product. If we think about this, we realize thatnothing is free—we are paying for the complete package. Yet,the popularity of this type of sales pitch suggests that it works.Alternatively, we are less affected by one big loss than a numberof small ones of equal value. One of the appeals of credit cardsis that they give us the bad news as one number. Also, sellersknow that when we make a large purchase, they have anopportunity to sell us even more. If we are paying Rs.100,000for a house, an extra Rs.1000 does not seem to be much to addon some conveniences. However, if we see the extra Rs.1000 asa completely separate transaction, we may react in a very differentway.Though the free trial with money-back guarantee is a way tosignal quality. it also takes advantage of our mental accounting.Once we have an item at home and in use, it becomes part ofthe status quo. Giving it up is coded as an actual loss rather thana gain not taken, and affects us more.If you are still dubious about people relying on mentalaccounting rules, ask yourself why so many prices are in nines:Rs.9.95, Rs.19.95, Rs.999.99, etc. Why not simply round themup to an even number? The author has been immersed ineconomics for almost 30 years, and finds it amusing that he hasmental accounting techniques that violate the logic of economicchoice and that they are so deeply ingrained he cannot get rid ofthem. If you start examining how you view the world, you willprobably find that you too often make decisions in ways thatviolate the logic of choice.Having seen that one can harbor reservations about thetraditional theory of choice, we next return to that theory to seewhy economists prefer cash to in-kind transfers.
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In-Kind And Cash TransfersSuppose that an eccentric millionaire decides to help a poorneighbor by giving him Rs.1000 worth of nontransferable hatcertificates—certificates that could be used to buy hats butnothing else. Is this gift of the same value to the poor neighboras a gift of Rs.1000 in cash? Economists answer that generally agift in kind has less value than a cash gift because it hasrestrictions. A cash gift gives more options, and economistsusually assume that more options never harm a person, butmay help one.The argument that cash gifts are superior to in-kind gifts can beshown with budget lines. In the graph below, the poorneighbor originally faces budget line A-B. A gift of Rs.1000worth of hat certificates means the person could buy more hatsthan he could previously have bought, or if all income werespent on hats, he could buy O-E rather than the O-B that hecould have had before. There is no increase in Other Goods thathe can buy if he spends all his income on them. As a result, thenew budget line is A-C-E. A gift of Rs.1000 in cash, on theother hand, would increase not only the number of hats that ispossible, but also the amount of Other Goods. The newbudget line with a cash gift is D-C-E. The dotted portion D-Crepresents the options that cash gives, but which the in-kindtransfer does not allow. Because few people spend very much oftheir incomes on hats, most people prefer to be on the segmentD-C rather than C-E. In this case, the gift in kind is lessvaluable to the recipient than a gift in cash.
This analysishas underlying assumptions, as all economicanalyses do, and if these assumptions do not hold, the aboveconclusion may not either. First, it assumes that there is no costin making decisions. Making decisions often involves gatheringinformation, weighing it, and worrying about whether thedecision is correct or not. Anyone who has had to choosebetween two good job offers knows the agony that making adecision can entail. Further, some people recognize that they donot make good decisions and hire others to do so for them.This shortcoming explains the career of financial advisor, inwhich people draw up budgets for others and in some casesmake the actual purchases. Thus, if the giver knows of itemsthat the recipient would like but does not know about, if thecost of making decisions is high, or if the individual is notcapable of making decisions that get him to his goal, therecipient may be better off with the in-kind transfer than with acash transfer.Most gifts between friends are not for cash but are in-kind gifts.Most girls would be upset if their boyfriends gave them moneyfor birthdays or Christmas. Gifts between friends are a way ofcementing ties and give rise to obligations. They play animportant role in helping small-group associations runsmoothly. An in-kind gift indicates that the giver is interested
enough in the recipient to learn about the recipient’s likes anddislikes, and has spent time doing this and in obtaining the gift.The simple economic analysis of our graph does not capturethese subtleties. Though anthropologists have studied gift-giving more than economists, some economists do consider itimportant. For example, Kenneth Boulding’s Economics of Loveand Fear argues that there are three mechanisms that help holdgroups together: the integrative mechanism of gift-giving andlove, voluntary and mutually advantageous exchange, andcoercion and threat.Third, the economic analysis of the picture above refers only tothe recipients’ preferences, not to those of the donors. A donormay disapprove of the goals that the recipient pursues, andthus may be unwilling to let him make choices. Economists area bit unusual because they generally assume that people knowwhat is best for themselves. As a result, most are reluctant toapprove of desires of donors to deny choices to recipients.A final reservation with the above analysis is that people oftenpursue goals that involve status, and pursuit of status is a zero-sum game. When one person rises in status, others must fallrelative to him. If I am forced to help others, I will be lessresentful if my help does not change their status, especially ifthose being helped are close to me in status. One way to makesure that my help does not change their status is to give themspecific goods that have no status: things such as free healthcare, public housing, and free food. In contrast, giving othersmoney allows them to purchase items that convey status, suchas fancy cars and faddish brands of shoes and clothing. Peoplewho receive government aid and who have new cars are oftenintensely resented by those who almost qualify for the aid.Perhaps an important reason for the persistence of many formsof in-kind grants in the face of the opposition of so manyeconomists is that the economists are ignoring the quest forstatus.The question of whether in-kind transfers are better than cashtransfers is important when governments devote hundreds ofbillions of dollars to transfers. At one time the governmentgave food to the poor; now it gives food stamps. The in-kindversus cash argument was involved in the switch (though it maynot have been the decisive factor). The government attempts tohelp poor people by building and providing public housing;would the poor be better off if the government providedmoney instead of the housing? The government provideseducation by providing free schools, but students can rarelychoose which free school they attend. Would they be better offif the government stopped producing education and insteadprovided them with a “tuition voucher,” a sum of moneywhich they could use at the school of their choice? The presentsystem of transfers is a mixture of cash and in-kind transfersthat is only partially explainable in terms of the recipients’welfare.The topic of present value follows naturally from the discus-sion above.
9.1.1 Present ValueSuppose that someone will give you a gift of Rs.100, and willgive it to you either now or in four years. Which is better, themoney now or the money four years from now? The rule that
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gifts with restrictions are of less value than gifts withoutrestrictions suggests that money now is worth more thanmoney in the future. Anything that one can do with the gift ofRs.100 four years from now one can do with Rs.100 nowsimply by saving it for four years. But there are many things thatone can do with money now that one cannot do with moneyfour years from now. Therefore, Rs.100 promised four yearsfrom now is not worth Rs.100 right now, but a smalleramount.One of the things that can be done with money now is toinvest it so that it will earn interest. Because this cannot be donewith money four years from now, this option of foregoneinterest is a cost of waiting for the money. When this cost ismeasured, one sees the amount by which money in the futuremust be discounted to obtain its present value.If the interest rate is 10%, Rs.100 now can be turned intoRs.110 one year from now. Thus, Rs.100 now and Rs.110 a yearfrom now have the same value. (You may have to think aboutthis for awhile.) This simple idea is vital in business andgovernmental decisions because a great many decisions havecosts and benefits spread over time, and it is often necessary tocompare sums in different time periods.Computing the present value of future sums is nothing morethan working compound interest problems backward. Theformula for finding the future value of a present sum after oneperiod is(1) P + Pr = For(2) P(1 + r) = Fwhere P is the present sum, r is the interest rate in decimal form,and F is the future sum. (Try the formula for P = Rs.100 and r= .10. You should get F = Rs.110.)After two years the amount of money will be(3) F1(1 + r) = F2where F1 is the amount of money one year from now, and F2is the amount of money two years from now. This may berewritten as(4) (P(1 + r))(1 + r) = P(1 + r) 2 = F2.(Try this formula for P = Rs.100 and r = .10. F2 should beRs.121.) Using the same logic, the future value three years fromnow will be(5) P(1 + r) 3 = F3and for any arbitrary period n, it will be(6) P(1 + r)n = Fn.Simple algebra allows us to solve this equation if we have thetime period and two of the three remaining variables. (Loga-rithms help a lot if we are solving for r.) In particular, if wehave a future sum of money and want to find its present value,the last equation can be rewritten as(7) P = F / (1 + r)n
Using this formula in our case of Rs.100 four years from nowand an interest rate of 10%, the present value isP = 100/(1.10)4 = 100/1.464 = 68.30
This means that Rs.68.30 invested at 10% will grow to Rs.100four years from now. Therefore, Rs.68.30 now and Rs.100 fouryears in the future have equivalent value if the interest rate is10%.Present value analysis explains bond prices.
9.1.2 Bond Prices
Present value explains why the price of bonds on the bondexchange falls when interest rates rise and rises when interestrates fall. A bond is a contract. At the beginning of the contract,the lender pays a specified amount, usually Rs.1000 or amultiple of Rs.1000, to the borrower. The bond specifies whenthe Rs.1000 will be paid back, and how much will be paid asinterest each year and all other terms of the agreement. A bondissued in 1983, due in 2003, and paying Rs.130 a year interest (acoupon rate of 13%) has the stream of payments illustrated inthe table below. If the market rate of interest equals 13%, the1983 value of the Get column will equal Rs.1000.
What a Bond Does Year Give Get 1983 Rs.1000 Rs.0 1984 0 Rs.130 1985 0 Rs.130 1986 0 Rs.130
... ... ...
... ... ... 2001 0 Rs.130 2002 0 Rs.130 2003 0 Rs.1130
If the lender decides that he no longer wants to hold this bond,he cannot demand payment from the borrower because thecontract does not give the owner of the bond the right topayment on demand. But he can sell it to someone else, and theprice of this sale need not be Rs.1000. If market interest rateshave risen since the original purchase of the bond, the presentvalue of future payments in the Get column will drop, and sowill the value of the bond. Another way of seeing this principleis to realize that if the market interest rate rises to 15%, therewill be borrowers selling contracts for Rs.1000 that pay Rs.150each year until the maturity of the bond (when the contractends). It would be foolish to pay Rs.1000 to buy a contract thatpays only Rs.130 a year.The notion of present value may seem dry to someone whohas never owned a bond or made business decisions. But formany corporate financiers, and for those who have moneyinvested in bonds, it is a notion that provides a lot of excite-ment—both joy and woe—in their lives.The notion of rational consumers leads to an importantconcept called consumers’ surplus.
9.2 Consumers’ Surplus
The assumption that consumers maximize utility leads to thedownward-sloping demand curve. Actually, even non-rationalor random behavior will lead to a downward-sloping demand
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curve, as economist Gary Becker has demonstrated, but thisdemand curve does not have the same interpretation that ademand curve based on utility maximization (trying to attaingoals) has.Becker’s argument is quite simple. Because the budget line is aconstraint separating what is possible from what is notpossible, even non-rational consumers face a budget constraint.Becker notes that if people randomly purchase goods, they willbe randomly distributed, either along a budget constraint orwithin the area bordered by the budget constraint. (Beckerconsiders both cases.) If the price of a good increases, thebudget line will shift and a new random distribution of pointswill occur. The geometry of the situation implies that, on theaverage, people will buy less of a good as its price rises.
Though the demand curve of non-rational consumers willslope downward, it can no longer be interpreted as a locus ofpoints of consumer equilibrium. With the assumption ofutility maximization, the preferences and prices used toconstruct the graph above imply that q2 is the amount of goodA that is optimal for the consumer. If either more (q3) or less(q1) is being used, there is an incentive to change behaviorbecause it would lead to better fulfillment of goals. However, ifbehavior is random and not concerned with fulfilling goals,point x is as good as point z. Thus, the argument that pricecontrols have unintended results depends on the assumptionthat behavior is goal-directed.Utility maximization suggests that the demand curve, because itmeasures buyer’s willingness to pay, shows marginal benefits tobuyers. The table below indicates that people will buy only oneitem if the price is Rs.5.00, or that people are willing to payRs.5.00 for the first item. They are not willing to pay Rs.5.00 fora second item, but only Rs.4.00. A second item has a smallermarginal benefit than the first because of the law of diminish-ing marginal utility. The equimarginal principle suggests that asprice gets lower, consumers find that they must use more of anitem to keep equality among marginal-utility-to-price ratios.Alternatively, as people use more of an item, its marginal utilitydrops, and so must its price if they are to stay in equilibrium.
A Demand Curve
Price Amount People Are Willing to Buy
Rs.5.00 1 Rs.4.00 2 Rs.3.00 3 Rs.2.00 4 Rs.1.00 5 Rs.0.50 6
This notion of the demand curve has an interesting implicationknown as the consumers’ surplus. If in the table aboveconsumers are buying three items, they must pay a total ofRs.9.00. But the total value to them is Rs.5.00 + Rs.4.00 +Rs.3.00 = Rs.12.00. There is a surplus value of Rs.3.00. In amore intuitive example, suppose that a person has beenworking in the hot sun all afternoon and is extremely thirsty.This person may be willing to pay as much as Rs.2.00 for a canof cold beer, but if he can buy it for only Rs..50, he thinks hehas found a good deal and may buy two or three. The differencebetween the maximum a person would pay and the actualamount that he does pay is consumers’ surplus. In otherwords, consumers’ surplus is the difference between the valuein use of an item and its value in exchange.Notice that consumers’ surplus is not related to the type ofsurplus that occurs in a market when price is above market-clearing price. Perhaps economists would have avoided thispossible confusion if they had used a term other than consum-ers’ surplus for this concept, but they did not and the term isnow well-established.In the early days of economics people puzzled over what wascalled the paradox of value. This paradox disappears once weunderstand consumer surplus.
9.2.1 The Paradox of ValueWhy is it that some items that have relatively little use to society,such as diamonds, are extremely expensive, whereas others thatare vital, such as water, are inexpensive. Adam Smith and othereconomists for a century after him struggled unsuccessfully toexplain this Paradox of Value. Though Smith never unraveledthe paradox of value, you can do it easily with a little help fromthe concept of consumers’ surplus.To see how this paradox is resolved, consider again thedownward-sloping demand curve discussed earlier. As an itemgrows more abundant, its total use value to consumers, whichis the entire area under the demand curve, rises; but its price, orits marginal value to consumers, declines. Thus, if two items inthe table below are available, the total value to consumers isRs.9.00 (or Rs.5.00 for the first and Rs.4.00 for the second), butthe price or value in exchange is only Rs.4.00. If six are available,total use value rises to Rs.15.00, but exchange value (price)drops to Rs..50. Smith and his early followers missed thisdistinction between marginal and total. Thus, diamonds arescarce and have a high marginal value but a low total value.Another pound of diamonds has valuable uses that are notcurrently being met. Water is tremendously abundant and thushas a high total value and a low marginal value. Another gallonof water is not particularly important.
A Demand Curve
Price Amount People Are Willing to Buy
Rs.5.00 1 Rs.4.00 2 Rs.3.00 3 Rs.2.00 4 Rs.1.00 5 Rs.0.50 6
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If there is a consumers’ surplus, should there not also be aproducers’ surplus?
9.3 Producers’ SurplusSuppose that Charles considers a CD worth Rs.10 and Sam,who owns it, values it at only Rs.2.00. Sam agrees to sell it toCharles for Rs.5.00. We have seen that the value Charles gets butwhich he does pay for (Rs.5.00 in our example) is calledconsumers’ surplus. But what of the Rs.3.00 of value Sam getsbecause he sold something worth only Rs.2.00 to him forRs.5.00? There is a surplus here, and it is called either produc-ers’ surplus or economic rent.1 Producers’ surplus exists whenactual price exceeds the minimum price sellers will accept.Producers’ surplus can appear as profit, but usually it takes adifferent form. Suppose, for example, that the price of corn hasbeen Rs.2.00 per bushel for many years. Then it rises to Rs.3.00per bushel and stays there. This higher price will draw moreland into corn production, but this change is of no importancehere. What is of interest is what happens to the farmers whowere producing corn at Rs.2.00 per bushel and now find thatthey can sell corn at Rs.3.00. It certainly appears that thesefarmers are better off because a producers’ surplus of Rs.1.00per bushel has appeared that was not there before.However, let us separate farming into two parts: working theland and owning the land. Suppose that a farmer does not ownthe land he works, but rents it. It then becomes unlikely thatthis farmer will benefit at all from the higher price of corn. Ifthose working the land obtained the surplus, there would becompetition for the right to work land that is especially suitedto growing corn. This competition should raise the value of theland, and therefore it will be the landowners, not the cultivators,who benefit from the higher price of corn. Because the earliestcase of producers’ surplus analyzed was one in which landcaptured the surplus, the producers’ surplus is often calledeconomic rent.Producers’ surplus is usually captured by resource owners ratherthan by producers. Hence the producers’ surplus is not thesame as profit. The resources that capture the surplus are thosethat are especially good at producing the product in question orthat have no other uses, and hence will be used for that producteven when prices are low. Sometimes, the resource that captureseconomic rent is labor. The high pay that superstars in manyfields earn is mostly producers’ surplus. The basketball star paidRs.1 million who would still play for Rs.25,000 earnsRs.975,000 in producers’ surplus. There is an interestingconclusion to this observation: The reason basketball tickets arehigh-priced is not because star athletes have high salaries (asowners sometimes allege), but rather the salaries are highbecause fans are willing to pay so much for the tickets to see thestars play.We conclude this group of readings by putting the producers’and consumers’ surpluses together on a graph.
9.4 Producer And Consumer Surplus TogetherThe producers’ and consumers’ surpluses are illustrated withsupply and demand curves in the figure below. The total valueto consumers of quantity Q is represented by areas A+B+C.Because the consumers must pay B+C, only the area A issurplus for them. Producers get revenue of B+C. B is their
surplus because only payments of C are needed to attract theresources necessary to produce quantity Q.
The concepts of consumers’ and producers’ surpluses are toolsthat can help analyze many situations. For example, is there anytemptation for sellers to gang up on buyers? If sellers can raisethe price, can they transfer some of the consumers’ surplus tothemselves? They can, and the graph below illustrates whathappens. The consumers’ surplus at price Pc is A+B+D. Theproducers’ surplus at this price is C+E. By raising price to Pm,sellers cause the consumers’ surplus to shrink to the area A.Area B is transferred from consumers to producers, butproducers lose area E. If area B is greater than area E, this movebenefits producers. The new producers’ surplus is C+B. Ifsellers gang up on buyers, they are no longer price takers. Rather,the sellers leave the supply curve and search along the demandcurve for the best deal. As a result, such behavior is called“price searching.”
It is easiest for sellers to restrict output and raise price whenthere are very few sellers and many buyers. When there ismonopoly, which means there is only one seller, economistsexpect the seller to act in this way. With many sellers, coordina-tion of decisions becomes difficult (for the same reason that theproblem of the commons can exist) and output restrictionsbecome unlikely.Alternatively, buyers can gang up on sellers and extract produc-ers’ surplus. They must restrict purchases to drive the pricedown. Again, this behavior is likely only when there are very fewbuyers and many sellers. When there is only one buyer, amonopsonist, economists expect it to restrict purchases.What is good for the individual is not necessarily good for thegroup. Notice that the process of transferring the value of areaB from consumers to producers in the second graph abovecauses consumers to lose area D and producers to lose area E,and no one gets this lost value. In the process of increasingtheir surplus by seizing area B, producers cause the value oftotal surplus to shrink. There is a conflict here between theinterests of producers and society as a whole. This loss ofvalue, which is not offset elsewhere in the system, is the essenceof the economist’s case against monopoly.
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1. Case StudyWealth and HealthLead Story-dateline: The Economist, February 21, 2002.Obesity is no longer just a western disease. It is becoming aproblem in the developing world too. In 1991, 15% ofAmericans were obese; by 1999, that proportion had grown to27%. Ten percent of Americans under 17 are obese. Physicalactivity has declined and diets have expanded. Meanwhile,poorer nations have enjoyed some success in their battlesagainst malnutrition and famine. But, according to researchpresented at the annual meeting of the American Associationfor the Advancement of Science (AAAS), held on February 14th-19th in Boston, it is more a case of being out of the frying panand into the fire. Obesity, anthropologists believe, couldbecome an epidemic of the poor world as well as the rich one.It now seems that even modest increases in wealth in countriesundergoing industrialization are enough to tip their peoplefrom malnutrition to obesity. This increase in weight has beenuneven as well as fast. In India, a survey of 83,000 womenfound that although 33% were malnourished, 12% wereoverweight or obese. The mix can even occur within a singlehousehold.Another long-standing assumption about obesity in develop-ing countries might also need to be overturned. In thedeveloped world, obesity has become a disease of the poor,who eat chips and hamburgers while the wealthier sup on tofuand veggies, and hit the gym afterwards. The opposite wasthought to hold true in poor countries, where as a matter ofcourse only the upper classes could afford to eat enough to beoverweight. A series of studies in Brazil show that in urbanareas richer people eat more fruit and less sugar, and do moreexercise, than their poorer compatriots. In Mexico and theDominican Republic, a similar trend pertains.Diabetes, heart disease and other so-called “diet-related non-communicable diseases” will join the list of ailments strainingthe public-health facilities of poor countries. The number ofnew cases of adult-onset diabetes in China and India alreadyexceeds new cases in the whole of the rest of the world. Anepidemic of cardiovascular disease lies heartbeats away. There isreluctance on the part of governments to spend resources onpromoting diet and exercise while starvation is still a real threat.Thinking about the future!The availability of resources accessible to the rich versus thepoor, whether across countries or among persons within acountry, is astoundingly dissimilar, and hence, so too isconsumer choice. Scarcity of resources underlies consumerchoice, yet is insufficient in explaining idiosyncratic consumerdiets. The article notes that in both advanced and less-devel-oped countries, it is the poor whose diets are turning out obeseadults. Other things equal, you might expect that lower income
TUTORIAL 3
is linked to lower caloric intake. However, contributing toobesity among the impoverished are offsetting factors, includ-ing a predominance of high-calorie junk food in the diet,limited access to education and health care, exploitation, lack ofpolitical representation, and a multitude of stresses related todaily survival. Expectations of a bleak future can influence thepoor to seek sources of immediate gratification. Sugar and fat-based diets can bring pleasures today. And when ‘tomorrows’are perceived as bleak as ‘yesterdays,’ having it your way today atBurger King sounds increasingly like a rational consumer choiceamong the world’s poor.Talking it over and thinking it through!1. With a cornucopia of food products available in U.S. and
worldwide markets, why would rational consumers makedietary choices that tend to contribute adversely to theirhealth?
2. With regard to consumer choice, is there any implication inthe article that food is treated as a normal or inferior good?
Multiple Choice Questions
1. According to the marginal principle, if the marginal benefit isfar greater than the marginal cost, than a rational individualwill• stop the activity and enjoy the current profits.• stop the activity when marginal benefits are at their
highest overall level.• stop the activity when the marginal benefit is equal to the
marginal cost.• stop the activity only when there are no more remaining
resources.• none of the above are true.
2. Which of the following statements best describes totalutility?• Total utility decreases with each good a consumer
purchases.• Total utility increases at a decreasing rate with each good a
consumer purchases.• Total utility increases at an increasing rate with each good
a consumer purchases.• Total utility remains constant as the consumer purchases
more goods.• Total utility is the dollar value of all goods that a
consumer purchases.
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3. Roy recently bought a cat. He liked it so much that hebought two more. Eventually, when Roy had seven cats, hecomplained that it was not worth it to buy another. What isa possible explanation?• The law of diminishing marginal utility is in effect.• The supply curve for cats is downward sloping.• A consumer will always buy positive amounts of all
goods.• His demand curve has a positive slope.• Cats are an inferior good.
4. Kathy spends all her income purchasing pizza and soda. Theprice of pizza is $5, and the price of a soda is $1. What is themarginal cost to Kathy of purchasing one more pizza, interms of utility?• $1• $5• the marginal utility of one more soda• (marginal utility per soda)(5 sodas)• It depends on Kathy’s income.
5. Marginal utility is the• extra consumption divided by the amount of pleasure
gained from the consumption.• additional happiness gained by consuming one more unit
of a good.• enjoyment obtained by consuming all of a good.• total satisfaction of the last unit consumed.• average happiness from consuming some number of
goods.6. Claire’s total utility from 3 scoops of ice cream is 100. Her
total utility from 4 scoops of ice cream is 120. Claire’smarginal utility for the fourth scoop is• 115.• 100.• 30.• 20.• 10.
7. Tim likes rice. He begins to eat his first course of rice, butsoon stops eating that and begins eating his baked beansinstead. One could say• the rice was undercooked.• the beans have a higher marginal utility than the rice.• Tim is not really trying to maximize his utility.• for Tim, the rice now has a marginal utility of zero.• the rice has a higher marginal utility than beans.
8. For Betty, the marginal utility of the first candy bar she eats is$2.50. The marginal utility of the eighth candy bar is $0. Thismeans that if candy bars were free• Betty would eat an infinite amount.• Betty would probably not have any.• Betty would have as many as she had time to consume.
• Betty would have at least eight candy bars.• Betty would eat exactly 8 candy bars.
9. According to the utility-maximization rule, consumers willchoose combinations of ice-cream and pizzas such that• on the last unit of each good consumed, the marginal
utility per dollar spent on ice-cream is equal to themarginal utility per dollar spent on pizza.
• on the last unit of each good consumed, the marginalutility per dollar spent on ice-cream is greater than themarginal utility per dollar spent on pizza.
• on the last unit of each good consumed, the marginalutility per dollar spent on ice-cream is less than themarginal utility per dollar spent on pizza.
• on the last unit of each good consumed, the marginalutility of ice-cream is equal to the marginal utility ofpizza.
• none of the above are true.10.At Disneyland, there is an admission price to get into the
park, but after that, there is no charge per ride. You have towait in line longer for some rides than others. Do all rides atDisneyland have the same price?• Yes, because the price per ride is zero.• Yes, because the price per ride is the admission fee that
you paid to get in.• No, the rides with longer lines cost more in terms of
opportunity cost of time.• No, because marginal utility per ride diminishes with
every ride that you take, so additional rides are worthmore to you.
• No, because marginal utility per ride diminishes withevery ride that you take, so additional rides are worth lessto you.
3. Long Answer Questions
1. Carefully explain the relationship between the individualdemand curve, the marginal utility curve, and the marginalbenefit curve.
2. Consider your monthly food budget. Suppose you onlypurchase two food items each month, apples and cereal.Apples cost $2.00 a pound, while cereal costs $3.00 a box. Atyour current level of consumption, you are purchasing 10pounds of apples and 21 boxes of cereal. The marginalutility received from the last pound of apples and last boxof cereal is 40 and 30, respectively. Are you maximizing yourutility? If not, what actions could you take to maximize yourutility? Explain how you arrived at your answer.
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In this chapter we begin to investigate the theory of supply.Supply depends on the conditions of production, so we beginwith a study of production, and specifically ask how outputsvary when the quantity of one input used varies.Though economists are interested in many cases of unintendedconsequences, those unintended consequences that involvebusinessmen seeking their own gain have been at the heart ofeconomic analysis since Adam Smith. Smith noted that“It is not from the benevolence of the butcher, the brewer, orthe baker, that we expect our dinner, but from their regard totheir own interests. We address ourselves, not to their humanitybut to their self love, and never talk to them of our necessitiesbut of their advantages.”Since Smith, a great deal of intellectual effort has gone intoexploring the question of under what conditions the interestsof society will be served by businessmen seeking to make aprofit—in fact, this is the core of microeconomics. The readingselections present background material to this exploration byexplaining a large number of technical terms that economistsuse, and also by looking at a few of the simplifying assump-tions they generally invoke.After you complete this chapter, you should be able to:• Define production function, isoquants, marginal product,
price discrimination, monopsonist, and the all-or-nothingdemand curve.
UNIT IIITHE BUSINESS ORGANISATION
CHAPTER 4:THEORY OF PRODUCTION
• Define increasing, decreasing, and constant returns to scale.• Distinguish between income and substitution effects.• Distinguish between an individual buyer’s demand curve and
the industry demand, and between industry demand and thedemand curve facing an individual seller.
• Compute marginal revenue from the demand curve of theseller when that demand curve is given in the form of atable.
• Compute marginal resource cost from the supply curve ofthe buyer when that supply curve is given in the form of atable.
• Explain why marginal resource cost equals price for a buyerwho is a price taker.
• Explain why marginal revenue equals price for a seller who isa price taker, and why marginal revenue is less than price for aseller who is a price maker.
• Explain what the law of diminishing returns is and underwhat conditions it holds.
• Explain why the demand curve, the supply curve forresources, and the production function can be treated asboundaries.
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LESSON 11:THE FIRM AND ITS PRODUCTION
An exchange is a voluntary agreement between two people, inwhich each gives something to the other and gets in returnsomething that he considers of greater value. When John andJim exchange baseball cards, John gets cards that he considersmore valuable than those he gives to Jim, and Jim gets cardsthat he considers more valuable than those he gives to John.Unless both sides of the exchange feel that the exchangebenefits them, the exchange will not take place. Because bothsides benefit, exchange is, in the terms of game theory, apositive-sum game.An alternative to interaction by exchange is interaction thatinvolves coercion. With coercion, the actions of one side arenot voluntary but forced. If Jim takes baseball cards away fromJohn and threatens to beat him up if he complains, we haveinteraction based on coercion. Economics focuses almostexclusively on interactions based on exchange and ignores thosebased on coercion. As a result, it has much more to say aboutmarkets than about government, which is the primary agent ofcoercion in society.People engage in exchange to attain goals. Exchange is not justtake; in order to get, one must give. People must do thingsthat they do not want to do in order to get things that theydesire. The unpleasant part of this process is work andproduction, and the pleasant part is consumption. Work andproduction are not pursued for their own sakes, but onlybecause without them we cannot consume. This division ofeconomic life is illustrated below in what Frank Knight calledthe Wheel of Wealth, but which is now more commonlyknown as circular flow.
The circular flow diagram divides the economy into two sectors:one concerned with producing goods and services, and theother with consuming them. Resources are converted intogoods and services by business, and in this transformed statetravel back to consumers. Money flows in the oppositedirection. These flows involve two markets in which exchangetakes place: the resource or factor market in which businessbuys resources, and the goods and services market in whichbusiness sells goods. Some economists define a “factor ofproduction” as the service of some resource . If resources areland, labor, and capital, the factors of production are theservices of land, labor, and capital. I will ignore the distinctionbetween resources and factors of production in the discussionthat follows.Both the model of supply and demand and consumer choicewith utility analysis are key elements of an understanding of an
exchange economy. However, this group of readings empha-sizes the right side of the circular flow diagram, examining thebusiness firm and the constraints or limitations that it mustface in its fight for survival.The economic theory of the firm is founded on the threefundamental tasks of a firm.
11.1 Three Fundamental TasksThe right side of the circular flow diagram shows the threefundamental tasks of all firms in an exchange economy. First, afirm must obtain inputs. Inputs include raw materials, energy,machinery, office space, workers, and anything else needed toproduce output. Second, the firm must combine or use inputsto produce output. Output may either be a tangible good suchas a pair of shoes or an automobile, or a service such as ahaircut or a medical checkup. Third, the firm must sell itsoutput to someone else.
A firm that cannot do these three tasks well enough will notsurvive. When the automobile was developed in the early 20thcentury, firms that made carriages died because they could nolonger do task three, selling their output, well enough. Almostall baskets sold in the United States are imported. Baskets arehandmade, and no firm in the United States can hire workers atwages low enough to be able to compete with wages that areacceptable in some other countries. Here is a case in whichAmerican firms (or firms in any industrialized nation) havedifficulty coping with the first task. The development of theelectronics industry is a case in which the second task haschanged. New technology allows firms to combine inputs toproduce goods that were not possible just a few years ago.The economic theory of the firm is an analysis of the way thefirm must perform these three tasks to make a profit. Each taskcan be described in mathematical or graphical terms. Supplycurves of resources describe the first task. They indicate howmuch the firm must pay for the amount of inputs it wants.The production function describes the second task. It tells howmuch output the firm can produce from a set of inputs. Thedemand curve for output describes the third task. It dependson people’s wants or preferences and tells how much the firmcan charge for output. Each of these mathematical ways ofrepresenting the three fundamental tasks can be seen as aconstraint or limitation that the firm faces.
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A supply-of-resources curve tells at what prices variousamounts of a resource can be bought or hired. Though one canview it in a number of ways, it also can be viewed as a bound-ary. It tells the firm the minimum it can pay for any amount ofa resource. Sellers of resources imposed this boundary on thefirm, which must buy resources in order to produce. Points tothe upper left of a supply curve are attainable, whereas those tothe lower right are not.The production function contains information about howmuch output can be obtained with various quantities of inputs.The production function is often discussed as a relationshipbetween inputs and output, as its name implies. (Mathemati-cally, a function is a special sort of relationship.) However, it toocan be discussed as a boundary. It shows the maximum that canbe produced with any combination of resources. Less than thismaximum can be produced—one can always get nothing forsomething.The demand curve can be viewed from a number of perspec-tives: as a relationship between price and quantity buyers willbuy, as a locus of points of consumer equilibrium, as a measureof marginal benefit to the buyer, or as a boundary. This lastview, that the demand curve represents a boundary that buyersimpose on the seller, is one that is most useful when develop-ing the theory of the firm. The demand curve limits theamount that sellers can sell at each price. Points to the left of thedemand curve are attainable, while those to the right are not.The remainder of this group of readings takes a closer look atthese three constraints. The material is somewhat technical, butit contains much of the core of microeconomics.Next we look more closely at the relationship between produc-tion and supply.
11.2 Production and SupplyIn investigating the foundations of supply and demand, wewill look at demand and supply as separate headings. It doesn’tmatter much, logically, which we take first. Historically, the firststages of the economists’ Reasonable Dialog were focusedmore on supply. In investigating the foundations of supply, weare investigating the economics of production, and that was thecentral topic for the classical economists.Adam Smith, we recall, had been very optimistic about thefuture economic development of the industrializing countries.With increased division of labor leading to higher wages andgrowing demand, he felt, production could continue to grow.However, Thomas Malthus criticized Smith’s optimism.Malthus spoke for the pessimistic view, and, of course, Malthusis best known for his claim that increasing population wouldlead to poverty. In supporting this idea, Malthus began to studythe limits on production. It was this study that has made hiswork important particularly for Neoclassical economics.Limits on production stem from limited resources with a giventechnology. With a given technology, limited quantities ofinputs will yield only limited quantities of outputs. Therelationship between the quantities of inputs and the maxi-mum quantities of outputs produced is called the “productionfunction.”
The “production function.” is a relationship between quantitiesof input and quantities of output that tells us, for each quantityof input, the greatest output that can be produced with thoseinputs. Malthus didn’t work out the details, but he clearly hadthis idea in mind as he originated the key concept of Diminish-ing Returns.
11.3 Diminishing ReturnsAs we recall, Malthus is best known for his pessimistic idea thatpopulation growth would force incomes down to the subsis-tence level. What we are interested in here is not his conclusion,but the reasoning that took him there.Malthus argued that land is a fixed input, but the growth ofpopulation makes labor a variable input. Malthus proposed ageneral law of economics, the Law of Diminishing Returns:when a fixed input is combined in production with a variableinput, using a given technology, increases in the quantity of thevariable input will eventually depress the productivity of thevariable input. (Malthus argued that decreasing productivity oflabor would depress incomes).Was Malthus right? The answer is, of course, yes and no.There is plenty of evidence, both observational and statistical,that the Law of Diminishing Returns is valid. For example,agricultural economists have carried out experimental tests ofthe theory. They have selected plots of land of identical size andfertility and used different quantities of fertilizer on thedifferent plots of land. In this example, land was the fixedinput and fertilizer the variable input. They found that, as thequantity of fertilizer increased, the productivity of fertilizerdeclines. This is only one of many bits of evidence that the Lawof Diminishing Returns is true in general.On the other hand, in the two hundred years since Malthuswrote, on the whole, population has increased but laborproductivity and incomes have not declined. On the whole, theyhave risen. What seems to have happened is that technology hasimproved. Malthus recognized that if technology improved (inagriculture, at least), that might postpone what he saw as theinevitable poverty as a consequence of rising population. Someeconomists, and other people, believe that the Malthusianprediction will eventually come true. Perhaps: what is clear isthat in two hundred years it has not.But that doesn’t mean the Law of Diminishing Returns iswrong! A “law” such as this can be true in general but cannot beapplied when its assumptions (such as an unchanging technol-ogy) aren’t true. The “Law” isn’t wrong — just inapplicable tothat case.There are many valid and useful applications of the Law ofDiminishing Returns in economics. In this chapter we will lookat two.• We will use Diminishing Returns and related concepts to get
a better idea of the meaning of the phrase “efficientallocation of resources” and some guidelines for efficiency inthat sense.
• We will explore how a business firm should direct itsproduction in order to get maximum profits, and that willgive us a basis for a better understanding of the economicsof supply.
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First, though, we will need to look at production and diminish-ing returns in general in a little more detail.
10.4 The Production FunctionProduction is the transformation of inputs into outputs.Inputs are the factors of production — land, labor, and capital— plus raw materials and business services.The transformation of inputs into outputs is determined bythe technology in use. Limited quantities of inputs will yieldonly limited quantities of outputs. The relationship betweenthe quantities of inputs and the maximum quantities ofoutputs produced is called the “production function.”But how do these outputs change when the input quantitiesvary? Let’s take a look at an example of a production function.When most people think of fundamental tasks of a firm, theythink first of production. Economists describe this task withthe production function, an abstract way of discussing how thefirm gets output from its inputs. It describes, in mathematicalterms, the technology available to the firm.A production function can be represented in a table such as theone below. In this table five units of labor and two of capitalcan produce 34 units of output. It is, of course, always possibleto waste resources and to produce fewer than 34 units with fiveunits of labor and two of capital, but the table indicates that nomore than 34 can be produced with the technology available.The production function thus contains the limitations thattechnology places on the firm.
A Production Function Labor
5 30 34 37 4 26 30 33 3 21 25 28 2 16 20 23 1 10 13 15 1 2 3
Capital
The production function can also be illustrated in a graph suchas that below. This graph looks exactly like a graph of indiffer-ence curves because the mathematical forms of the productionfunction and the utility function are identical. In one case,inputs of goods and services combine to produce utility; in theother, inputs of resources combine to produce goods orservices. A curved line in the graph shows all the combinationsof inputs that can produce a particular quantity of output.These lines are called isoquants. As one moves to the right, onereaches higher levels of production. If one can visualize this as athree-dimensional graph, one can see that the productionsurface rises increasingly high above the surface of the page; theisoquants indicate a hill. The firm must operate on or belowthis surface.
11.4.1 Marginal ProductivityProductivity, by definition, is a ratio of output to labor input.In most statistical discussions of productivity, we refer to theaverage productivity of labor:
Average labor productivity is an important concept, especially inmacroeconomics. In microeconomics, however, we will focusmore on the marginal productivity. We can think of themarginal productivity of labor asthe additional output as a result of adding one unit of labor,with all other inputs held steady and ceteris paribus.In algebraic terms, an equally correct definition is:
Let’s have a numerical example to illustrate the application ofthe theory. Suppose that:• When 300 labor-days per week are employed the firm
produces 2505 units of output per week.• When 400 labor-days per week are employed the firm
produces 3120 units of output per week.• It follows that the change in labor input, •Labor, is 100.• It also follows that the change in output, •Output, is 615.• Applying the formula above, we approximate the marginal
productivity of labor by the quotient 615/100 = 6.15.• We can interpret this result as follows: over the range of 300
to 400 man-days of labor per week, each additional workeradds approximately 6.15 units to output.
Of course, if we had more information, we could get a closerapproximation. For example, if we had the outputs for 310,320, ... 390 man-days of labor, we could see how MP varieswithin the range 300-400. But we can be sure that the values willbe in the neighborhood of 6.15.Let’s extend the numerical example in the page and see howmarginal productivity varies over a wide range of labor inputs.Here is a hypothetical example of production with the inputsof land and labor held steady and varying quantities of labor,and the output and average and marginal productivities.
Labor Output Average Productivity
Marginal Productivity
0 0 0 100 945 9.45 9.45 200 1780 8.90 8.35 300 2505 8.35 7.25 400 3120 7.80 6.15 500 3625 7.25 5.05 600 4020 6.70 3.95 700 4305 6.15 2.85 800 4480 5.60 1.75 900 4545 5.05 0.65 1000 4500 4.50 -0.45
11.4.2 Average and Marginal ProductivityWe have put some stress on the difference between average andmarginal productivity. Both are important, but for a model of
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short-run profit-maximizing supply, marginal productivity isthe more important. and the two are quite different.Here are the average and marginal productivities for the samenumerical example in the page before last. Notice how bothaverage and marginal productivity decrease as the labor inputincreases. But the marginal productivity declines faster than theaverage productivity, pulling the average productivity down afterit. The downward slope of the marginal productivity lineexpresses the Law of Diminishing Returns, and the downwardslope of the average productivity is also a result of the law.
Figure 2: Average and Marginal ProductivityThe relationship between average and marginal productivity inthe diagram is important in itself, and we will see similarrelationships in future chapters. So let’s look at it a little moreclosely. Average and marginal productivity will not always havethe same slope. In general,• whenever average productivity is greater than marginal
productivity, average productivity will slope downward.• whenever average productivity is less than marginal
productivity, average productivity will slope upward.The diagram does not show any values where average produc-tivity is less, but a more complicated example might, and thenwe would see the second part of the relationship visualized.To understand the relationship, think of it this way: as we addlabor input, one unit after another, we add a bit more to outputat each step. When the addition is greater than the average, itpulls the average up toward it. When the addition is less thanthe average, it pulls the average down toward it.Now let’s analyse the above example to understand Law ofDiminishing Returns .
11.5 The Law of Diminishing Marginal ProductivityIn his discussions of the Law of Diminishing Returns,Malthus did not distinguish between average and marginalproductivity. However, in modern economics, we think ofdiminishing returns primarily in terms of marginal, not average,productivity. Thus, we would state the law this way:Law of Diminishing Returns (Modern Statement):When the technology of production and some of the inputsare held constant and the quantity of a variable input increasescontinually, the marginal productivity of the variable input willeventually decline.
The inputs that are held steady are called the “fixed inputs.” Inthese pages we are treating land and capital as fixed inputs. Theinputs that are allowed to vary are called the “variable inputs.”In these pages we are treating labor as the variable input.Another way to express the law of diminishing returns, is that,as the variable input increases, the output also increases, but at adecreasing rate. The marginal productivity of labor is the rate ofincrease in output as the labor input increases. To say thatoutput increases at a decreasing rate when the variable inputincreases is another way to say that the marginal productivitydeclines.Here is a picture of the relationship between the variable inputand the output in the numerical example in the previous table.Notice how the slope gets flatter: as the variable input increases,output increases at a decreasing rate. This is a visualization ofthe Law of Diminishing Marginal Productivity.
Figure 1. Production with Diminishing ReturnsThere is one rule that seems to hold for all production func-tions, and because it always seems to hold, it is called a law. Thelaw of diminishing returns says that adding more of oneinput while holding other inputs constant results eventually insmaller and smaller increases in added output. To see the law inthe table above, one must follow a column or row. If capital isheld constant at two, the marginal output of labor (whicheconomists usually call marginal product of labor) is shownin the table below. The first unit of labor increases productionby 13, and as more labor is added, the increases in productiongradually fall.Marginal Product, as you already know, is the change inoutput with the increase of one additional unit of input.
The Marginal Product of Labor Labor Marginal Output First 13 Second 7 Third 5 Fourth 5 Fifth 4
The law of diminishing returns does not take effect immedi-ately in all production functions. It is possible for the first unitof labor to add only four units of output, the second to addsix, and the third to add seven. If a production function hadthis pattern, it would have increasing returns between the firstand third worker. What the law of diminishing returns says is
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that as one continues to add workers, eventually one will reach apoint where increasing returns stop and decreasing returns setin.The law of diminishing returns is not caused because the firstworker has more ability than the second worker, and the secondis more able than the third. By assumption, all workers are thesame. It is not ability that changes, but rather the environmentinto which workers (or any other variable input) are placed. Asadditional workers are added to a firm with a fixed amount ofequipment, the equipment must be stretched over more andmore workers. Eventually, the environment becomes less andless favorable to the additional worker. People’s productivitydepends not only on their skills and abilities, but also on thework environment they are in.The law of diminishing returns was a central piece of economictheory in the 19th century and accounted for economists’gloomy expectations of the future. They saw the amount ofland as fixed, and the number of people who could work theland as variable. If the number of people expanded, eventuallyadding one more person would result in very little additionalfood production. And if population had a tendency to expandrapidly, as economists thought it did, one would predict that (inequilibrium) there would always be some people almoststarving. Though history has shown the gloomy expectationswrong, the idea had an influence on the work of CharlesDarwin and traces of it still float around today among environ-mentalists. The second boundary that limits the firm is thedemand curve for output.
11.6 Demand Curve for OutputOnce a firm has produced a product, it must sell it. Thedemand curve for output describes the limitations the firmfaces in doing this task. The demand curve for output is aconstraint on the firm because it gives the maximum price that afirm can charge for each level of production. Thus, if the firm inthe graph below wants to sell 24, it can do so by chargingRs.5.00 or any price that is lower. It cannot charge Rs.10.00 andstill sell 24 because buyers will not allow it.
The demand curve facing a firm depends both on the prefer-ences of consumers and on how well other firms meet thosepreferences. One can derive a demand curve for an individualfrom a set of indifference curves showing the individual’spreferences and a series of budget lines showing changes inprice. To get a demand curve for the entire industry, one mustadd up all the demand curves of individuals. To get thedemand curve for eggs, for example, one must add up the
number of eggs that Smith and Jones and Nelson and all otherconsumers in the market want at each possible price.When there is only one firm selling in a market, that firm is amonopolist. (The Greek root mono- means “one.”) Thedemand curve for the monopolist is the demand curve for theindustry. A monopolist is a price searcher or a price maker. Itwill search along the demand curve for the price-quantity pairthat is most profitable. When there is more than one seller, thedemand curve that a seller sees is not the same as the demandcurve for the industry. The industry demand is split up amongsellers. When there are only a few sellers, the sellers will still beprice searchers or price makers. These sellers, or oligopolists(the Greek root oli- means “few”), are price makers because eachrecognizes that if it wants to sell more, it must lower its price.However, the demand curve of each oligopolist will be moreelastic than the demand curve for the industry as a whole.Suppose, for example, that there are two firms in an industry,each produces 50 units of output, and the elasticity of theindustry demand curve is one. If one firm increases its outputby 10% to 55, the industry output increases to 105, which is a5% increase. Since the price elasticity of demand is one, pricemust decline by 5%. But for the original firm, a 10% increase inproduction and a 5% decline in price indicate a price elasticity oftwo, not one.As firms get more and more numerous in an industry, thedemand curve each sees gets more and more elastic. When thereare a great many sellers in the market, a change of output by anyone of them has an insignificant effect on price. To each firm,the demand curve will look perfectly flat—the firm will seemable to sell whatever amount it wants at a fixed price. In thiscase, each firm is a price taker and sells in a perfectly competi-tive market. An example of this type of market is the marketfor wheat. There are a great many wheat farmers in manycountries, and none has any noticeable control over the price atwhich it can sell in the world wheat market.However, even when there are a great many sellers, each firmmay have a downward-sloping demand curve. If buyers mustexpend time and effort to discover prices or the characteristics ofthe product, they will pick a seller and stay with it as long as theyfind the exchange satisfactory. These downward-slopingdemand curves of small sellers are a result of the ambiguousdefinition of industry. The products most firms produce differin some way, such as in quality, service, or location, from theproducts of other firms in the industry.From the viewpoint of the firm, it is not the demand curve,but the child of the demand curve, the marginal revenue curve,which is of vital importance. Marginal revenue is the extrarevenue a seller gets when it produces and sells another unit.For the price taker, the marginal revenue curve is the demandcurve. For the farmer who can sell corn at Rs.4.00 a bushel, theextra revenue from selling another bushel is Rs.4.00. Thedemand curve for this farmer is flat at Rs.4.00, and so is hismarginal revenue curve.The table below illustrates why marginal revenue will be lessthan price for a price searcher. If the firm charges Rs.3.00, it cansell one unit and total revenue will be Rs.3.00. If it sells onemore unit, it will be forced to cut price to Rs.2.00 and total
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revenue will rise to Rs.4.00. Selling the extra unit adds onlyRs.1.00 to revenue. Although the second unit sold for Rs.2.00,the firm had to cut the price it was previously receiving for thefirst unit by Rs.1.00, so the net increase in revenue was onlyRs.1.00. By similar logic, selling the third unit reduces totalrevenue by Rs.1.00, so marginal revenue is -Rs.1.00.
Demand and Marginal Revenue Price Quantity Marginal Revenue Rs.3.00 1 .
. Rs.1.00 Rs.2.00 2 .
. -Rs.1.00 Rs.1.00 3 .
The previous analysis assumes that the firm can charge only oneprice. If it can charge more than one price, charging higher pricesto those willing and able to pay them and lower prices toothers, it can move the marginal revenue curve closer to thedemand curve, increasing profits (or reducing losses). Thispattern of pricing is called price discrimination.Economists generally assume that the demand curve is fixed,but many businesses do not regard it that way. It can varyseasonally, with the general level of business activity, or with atrend. The demand for turkeys has a pronounced seasonalmovement. The demand for automobiles changes when there isa recession. The demand for baby food follows the trends inbirth rate.Business also may be able to move its demand curve throughadvertising. Advertising may simply give people information, itmay change their goals, or it may change their perception of theproduct. For the firm it does not matter which happens. Theresult is the same—good advertising moves the demand curveto the right.The demand curve can move for other reasons. If a firm lowersits price and later raises it back to its previous level, it may findthat sales at the old price have changed. The lower price mayattract new customers who have not tried the product before,and who find they like the product enough to stick with it whenthe old price is restored. Alternatively, some customers mayexpect prices to be cut again sometime in the future, and maydecide to postpone purchases until it happens again. Theopposite can happen if the firm temporarily raises price. It mayencourage some customers to try substitutes, which they mayfind suit them better than the original product. Or it mayencourage customers to buy more when the price comes downto prepare for any future increase.The firm may also be able to change its demand curve bychanging the characteristics of its product.Finally, many firms sell several products that may be interrelated,and any pricing decision on one product will have effects notonly on that product but on others. For example, the prices thatGeneral Motors charges for Chevrolets will affect the demandcurve for Pontiacs.The third and final boundary the firm faces is the supply curvefor resources.
11.7 Supply of ResourcesThe third task of the firm is to obtain resources needed toproduce a product. For each resource, a supply curve showslimitations that the firm faces. These supply curves are based onthe preferences of sellers and on the actions of other firmswhich use the resource.Because a market demand curve can be derived from utilitycurves and a budget line, it may seem surprising that a supplycurve can also be derived from the same procedure. To see thatit can, consider the graph below which shows indifferencecurves for income and leisure. Income is desirable because onecan obtain other desirable things with it, and leisure is desirablebecause it lets one enjoy income.
In the world we live in, greater amounts of income must bepurchased with more work—which means less leisure. Thetradeoff between leisure and income, shown by the budget line,depends on the wage rate. If the wage rate is Rs.10, optionsopen to an individual include 24 hours of leisure and noincome, or 20 hours of leisure and Rs.40 of income, or 10hours of leisure and Rs.140 of income.To get a supply curve for labor, one must see what happens ifthe wage rate changes. Two wage rates are shown in the graphabove. At the higher wage rate, the individual wants less leisure(which means he will work more as wages rise), but one couldas easily draw indifference curves that show the amount ofleisure rising as wages rise (which means he will work less aswages rise). Higher wages have two effects on the leisure-workdecision, and these two effects pull in opposite directions. Ahigher wage rate increases the benefits of working, causingpeople to substitute work for leisure. This is called the substi-tution effect and is caused by changes in the slope of thebudget line. Higher wages also increase income, and peoplewant more leisure with a higher income. This is called theincome effect of a price change, and is caused by changes in thedistance of the budget line from the origin.Usually the substitution and income effects reinforce each other,but they pull in opposite directions and almost cancel each otherout in the case of labor. Most economists believe that themarket supply curve for labor (found by adding up all thesupply curves of individuals) is close to a horizontal line.Supply curves for other resources can be obtained in similarways. The supply curve for capital, for example, depends ondecisions of people to consume now or to consume in thefuture. People who prefer to consume in the future will saveand make funds available to finance capital. Their “timepreference” determines the shape of indifference curves. Theslope of the budget line depends on the interest rates. The
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budget line tells how much one can get in the future if onesacrifices consumption now.Although the market supply curve for labor may be almostvertical, few firms see this supply curve. If many other firmsalso are buying labor, what one firm does may have little effecton the overall market. If the firm is so small in the market thatit can see no effects at all on the wage from its hiring decisions,it is a price taker. If it has some effect on wages, so that when itwants to hire more, it finds that wages rise, the firm is a pricemaker. The extreme case of a price maker is a monopsonist, thecase of only one buyer in the market. The supply curve for aresource that a monopsonist sees is the same as the marketsupply curve.The supply curve for a resource is a constraint or boundary onthe firm because it shows the minimum that the firm can payfor a level of the resource. If the firm is a price taker in theresource market, it will face a horizontal supply curve such asthat in the graph below. This curve indicates that any numbercan be bought at P1 with no effect on price. There is no way thefirm can attain point a even though it might prefer to pay lessthan P1 because no one will sell at less than P1. Sellers will notsell because we assumed that there were a great many otherbuyers of the resource who will pay P1. Point c is possible, buta waste of money because the same amount of the resourcecould be bought for less.
If the firm is one of a few buyers or the only buyer of aresource, it may face a supply curve that slopes upward, makingit a price searcher. It can obtain quantity Q1 if it pays P1, but itmust pay more than P1 if it wants quantity Q2.You should have noticed that there are similarities between asupply curve for a resource and a demand curve for output.Both are boundaries, and the curve the firm faces may differfrom the market curve. The similarity goes further, becausethere is a counterpart for marginal revenue called “marginalresource cost” which measures the extra cost to the firm of hiringone more unit of the resource.When a firm is a price taker, marginal resource cost is the sameas the price of the resource. If the firm can hire as many workersas it wants at Rs.10 per hour, then hiring one more hour oflabor adds Rs.10 to costs. Marginal resource cost and the supplyof labor are both horizontal lines in this case.When a firm is a price searcher facing an upward-sloping supplycurve, the extra cost of hiring another unit of the resource isdifferent from the price of the extra unit. The table belowillustrates the reason for this difference. If the firm wants tobuy two units, it cannot pay Rs.1.00 and get two. It must bewilling to pay Rs.2.00 for each. However, the added cost of thesecond unit is not Rs.2.00, but Rs.3.00. This can be shown by
comparing the total cost of two units and one unit, or Rs.4.00less Rs.1.00. The added cost of the second unit is not only thetwo rupees that must be paid for it, but an added rupee for thefirst one. By the same logic, the added cost of a third unit isRs.5.00.
Computing Marginal Resource Cost Quantity Price Marginal Resource Cost 1 Rs.1.00 Rs.1.00 2 Rs.2.00 2.00 + 1.00 3 Rs.3.00 3.00+2.00
The marginal resource cost curve lies above an upward-slopingsupply curve because of the assumption that the firm can payonly one price. This is often a realistic assumption. If the firmhires two clerks who do exactly the same work, and pays oneRs.4.00 per hour and the other Rs.6.00 per hour, the lower-paidone will be unhappy and may refuse to work for the lower pay.On the other hand, many firms do not publicly disclose whatthey pay various people, and discourage employees fromdiscussing salaries. To the extent that people are unaware ofwhat others are earning, the firm may be able to pay differentprices for the same resource, or in economists’ jargon, to pricediscriminate. Price discrimination will pull down the MRC curvein the graph closer to, or perhaps even onto, the supply curve.
Next, we view a table that summarizes the many concepts inyou have read in this lesson.The major theme of the previous reading selections has beenthat in order to make a profit, a business must deal with threeconstraints or boundaries: the demand curve for output, theproduction function, and supply curves for inputs. The tablebelow shows how these concepts are related to the functions ofthe business and to the marginal concepts that are central inmicroeconomics.
The Constraints Facing the Firm
Task: Economic Concept
Limitation Imposed by
Relationship between
Marginal Concept
Buying inputs supply of resources
resource owners
price (money) and amount of resource
marginal resource cost
producing output
production function technology inputs and
output marginal product
selling output
demand curve customers output and
price (money) marginal revenue
The importance of these three constraints can be seen in aproduct that no firm can produce at a profit. Any one of threechanges, if large enough, can change the situation and make aprofit possible. The cost of the inputs may drop in priceenough so that the product is profitable. Or technology mayimprove enough to make the product profitable. Or people
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may increase the amount they are willing to pay for the productenough so that it is profitable. These three changes are changesin the supply-of-resources curves, the production function, andthe demand curve, respectively.
11.8 ApplicationDiminishing returns plays an important part in the efficientallocation of resources. For efficiency, of course, we want to givemore resources to the use in which they are more productive.But, as we give more resources to a particular use, we willobserve diminishing returns — that use will become lessproductive. That may sound frustrating, but in fact it leads to avery important principle we can apply to the problem ofefficient allocation of resources. We’ll explore this in the nextfew pages and we will see the same principle again and again inthe other chapters in this book.We are not done with the theory of the firm, but only justbegun. Next you will study the detailed analysis of economiesof scale.
Notes
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12.1 Law of Variable ProportionsLaw of variable proportions, sometimes also referred to as thelaw of diminishing returns, this “law” is really a generalizationeconomists make about the nature of technology when it ispossible to combine the same factors of production in anumber of different proportions to make the same product.The law states:When increasing amounts of one factor of production areemployed in production along with a fixed amount of someother production factor, after some point, the resulting increasesin output of product become smaller and smaller.(That is, first the marginal returns to successive small increasesin the variable factor of production turn down, and theneventually the overall average returns per unit of the variableinput start decreasing.) Since the law assumes that the availablequantity of at least one factor of production is fixed at a givenlevel and that technological knowledge does not change duringthe relevant period, the law of diminishing returns normallytranslates into a statement about the short-run choice ofproduction possibilities facing a firm (since in the longer run itis virtually always possible for the firm to acquire more of thetemporarily “fixed” factor — building an additional factorybuilding, buying additional land, installing additional machinesof the same kind, installing newer and more advanced machin-ery, and so on.)A simple example of the workings of the law of diminishingreturns comes from gardening. A particular twenty by twentygarden plot will produce a certain number of pounds oftomatoes if the gardener just puts in the recommendednumber of rows and plants per row, waters them appropriatelyand keeps the weeds pulled. If the gardener varies this approachby adding a pound of fertilizer to the topsoil, but otherwisedoes everything the same, he can increase the number ofpounds of tomatoes the garden plot yields by quite a bit (noticethe amount of land is being held fixed or constant). If he addstwo pounds of fertilizer (rather than just one), probably he canget still more tomatoes per season, but the increase in tomatoesharvested by going from one pound to two pounds offertilizer is probably smaller than the increase he gets by goingfrom zero pounds to one (diminishing marginal returns).Applying three pounds of fertilizer may still increase theharvest, but perhaps by only a very little bit over the yieldsavailable using just two pounds. Applying four pounds offertilizer turns out to be overdoing it — the garden yields fewertomatoes than applying only three pounds because the plantsbegin to suffer damage from root-burn. And five pounds offertilizer turns out to kill nearly all the plants before they evenflower.
LESSON 12:LAW OF VARIABLE PROPORTIONS
Another similar example of diminishing returns in an indus-trial setting might be a widget factory that features a certainnumber of square feet of work space and a certain number ofmachines inside it. Neither the space available nor the numberof machines can be added to without a long delay for construc-tion or installation, but it is possible to adjust the amount oflabor on short notice by working more shifts and/or taking onsome extra workers per shift. Adding extra man-hours of laborwill increase the number of widgets produced, but only withinlimits. After a certain point, such things as worker fatigue,increasing difficulties in supervising the large work force, morefrequent breakdowns by over-utilized machinery, or just plaininefficiency due to overcrowding of the work space begin to taketheir toll. The marginal returns to each successive increment oflabor input get smaller and smaller and ultimately turn negative.The law of diminishing returns is significant because it is partof the basis for economists’ expectations that a firm’s short-runmarginal cost curves will slope upward as the number of unitsof output increases. And this in turn is an important part ofthe basis for the law of supply’s prediction that the number ofunits of product that a profit-maximizing firm will wish to sellincreases as the price obtainable for that product increases.
12.2 Production with Two Variable Inputs: IsoquantsIn the first part of this lesson you viewed the followingproduction function:Q(L, K) = 1 * L0.5 * K0.5
If you haven’t done so already, go through the previous lessonfirst.The concept of marginal productivity is central to economists’understanding of efficient allocation of resources. For anillustrative example, consider a farmer who has two fields toplant. He can grow a crop of corn (let’s say) on each of them,but has a limited amount of labor to allocate between them.Let us say that the farmer can spend 1000 hours of labor, total,on the two fields. If he spends one more hour of labor on thenorth field, that means he has one hour less to spend on thesouth field.Here are the production functions for the two fields.Table 12.1
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Labor Input and Output on Two Fields
North Field South Field labor output labor output
0 0 0 0
100 9500 100 12107 200 18000 200 23429
300 25500 300 33964 400 32000 400 43714 500 37500 500 52679
600 42000 600 60857 700 45500 700 68250 800 48000 800 74858 900 49500 900 80679 1000 50000 1000 85715
We can visualize the production functions for the two fields.Figure 1, below, shows the production function for therelatively fertile south field with a vertically dashed purple curve,and the less fertile north field with a solid green curve. As wesee, the south field can always produce more, with the sameamount of labor, as the north field can.
Figure 12.1. Production Functions for Two Fields
12.3 The Problem of AllocationThe farmer’s “allocation problem” is: How much labor tocommit to the north field, and how much to the south field?One “common sense” approach might be to abandon theinfertile north field and allocate the whole 1000 hours of laborto the south field. But a little arithmetic shows that this won’twork. Here is a table that shows the correlated quantities oflabor on the two fields, and the total output of corn from bothfields taken together.Table 12.2
Allocation of Labor and Total Output on Two Fields
Labor on North Field
Labor on South Field
total output in bushels
of corn 0 1000 85000
100 900 89600 200 800 92400 300 700 93400 400 600 92600 500 500 90000 600 400 85600 700 300 79400 800 200 71400 900 100 61600 1000 0 50000
We see that the farmer gets his largest output by allocatingmost, but not all, of his labor to the south field. Because of theprinciple of diminishing returns, however, he shouldn’t put allhis resources into the one field, but divide the labor resource(unevenly!) between the two.But how much should go to the north plot, and how much tothe south plot?We can visualize the efficient allocation of resources with agraph like this one. The labor used on the infertile north field ismeasured on the horizontal axis and the total output fromboth fields in shown on the vertical axis. (We are assuming, ofcourse, that all labor not used on the North field is used on theSouth field). The dark green curve shows how total outputchanges as we shift labor from the north field to the south field.Thus, the top of the curve is the interesting spot — that’swhere we get the most output. In this example, that’s theefficient allocation of resources between the two fields.
Figure 12.2: Maximum ProductionIt’s easy to see that we should put some labor to work on thenorth field — but not too much. The vertical orange line showsthat the maximum output — the top of the dark green curve— comes when about 300 labor days are allocated to the north
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field and the rest, 700 labor days, to the south field. And that’sexactly right.It’s pretty easy to see where the maximum is in this simpleexample. But in a more realistic example, in which there couldbe many more than just two dimensions, it’s harder tovisualize. We need a rule that we can apply in more complex,realistic examples, a rule that will tell us if we have or don’t havean efficient allocation of resources.That’s where the economist’s “marginal approach” comes in.The objective is to get to the top of the hill. You could call “themarginal approach” the “bug’s-eye view.” Think of yourself as abug climbing up that production hill in the picture. How willyou know when you are at the top?
12.4 Marginal Productivity and AllocationIf you were a bug, you couldn’t see much. Perhaps you couldn’tsee to the top of the hill. But you would be able to tell if youwere going up, or down, or neither. So you would just keepgoing as long as you were going up, and stop when you wereneither going up nor down. That’s the way a bug gets to thetop of a hill.If you were a farmer with two fields, it’s a little more compli-cated, but the same principles apply: take it step by step.However much you may be producing, ask yourself “Whatwould happen if I were to take one worker away from theNorth Field and put her to work on the South Field? Howmuch less will the North Field produce? The answer to thatquestion is the marginal productivity of labor on the NorthField. How much more will the South Field produce? Theanswer to that question is the marginal productivity of labor onthe South Field. So the move of labor from the North Fieldwill increase production if the marginal productivity on theNorth Field is less than the marginal productivity on the SouthField. Like the bug, you want to keep moving in that directionas long as production keeps getting greater, that is, as long asthe marginal productivity on the North Field is less than themarginal productivity on the South Field. And you stop whenfurther movement won’t get you any higher on the hill, that is,when the marginal productivities are equal on the two fields.So now, let’s visualize the marginal productivities for these twofields. But this time we will do it a slightly different way. We willmeasure the labor used on the infertile north field from left toright on the horizontal axis. Then, what’s left is what’s availablefor the north field, so we will measure the labor used on thesouth field from left to right — from 1000 hours down to zero.The marginal product on the north field is shown with thegreen line, and the marginal product on the south field with thevertical-dashed purple line. (Remember, the marginal productiv-ity on the south field decreases as the labor input on the southfield gets bigger, so the marginal productivity on that fieldincreases as labor used on the field gets smaller, as it does here).Here it is:
Figure 12.3: Marginal Productivity and Efficient Allocation
12.5 Marginal ProductivityFigure 6 shows the most efficient allocation of resources in thiscase. It is to allocate 300 hours of labor to the north field, and700 hours to the south field, as shown by the vertical red-orange line. For maximum output, labor is allocated so that themarginal productivity of labor on the north field is equal to themarginal productivity of labor on the south field.
Figure 12.3: Efficient AllocationTo see why this works, think it through in reverse: whathappens if the allocation of labor is not 300 to the north fieldand 700 to the south field? For example, suppose 200 hours areallocated to the south field and 800 to the north field. This putsus to the left of the orange line — and we read off the diagramthat the marginal productivity of labor on the north field is 80bushels of corn, while the marginal productivity on the southfield is about 62. Remembering the definition of marginalproductivity, that means: if the farmer spends one additionalhour on the north field, he will gain 80 bushels, while spendingone less on the south field will cost him 62 bushels, leaving anet gain of 18 bushels. What has happened is that spending800 hours of labor on the south field has pushed the “dimin-ishing returns” on that field so far that it is less productive atthe margin than the north field. and that will be true anywhereto the left of the orange line, since, in that range, the marginalproductivity on the north field is always greater than themarginal productivity on the south field.Now let’s see what happens if the allocation is to the right ofthe most efficient one — for example, suppose the farmer wereto allocate 600 hours to the north field and 400 to the southfield. Looking at the diagram, we see that the marginal produc-
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tivity on the north field is 40 while the marginal productivity onthe south field is 90. Thus, moving an hour of labor from thenorth field to the south field will yield a gain of 90-40=fiftybushels of corn. And the farmer will continue to gain as hemoves toward the efficient allocation from the right, because, inthat range, the marginal product on the south field is alwaysbigger than the marginal product on the north field.We have seen that the farmer can gain by reallocating his laborfrom either side toward the efficient output. Once he has 300hours of labor on the north field and 700 on the south, thefarmer cannot increase his output any further. That is why wethink of it as the “efficient” allocation of resources.
12.6 Marginal Productivity and the EquimarginalPrincipleThis is a quite general principle, which we may state as follows.Rule:When the same product or service is being produced in two ormore units of production, in order to get the maximum totaloutput, resources should be allocated among the units ofproduction in such a way that the marginal productivity of eachresource is the same in each unit of production.This example may also be a little clearer example of what wemean by “efficient allocation of resources.” In the example, wehave a tiny economy, consisting of one farmer and two plots ofland. When the marginal productivities on the two plots areequal, this tiny economy has an “efficient allocation of re-sources.” Of course, real economies are more complex, but theprinciples governing the efficient allocation of resources are thesame.This rule has a name: it is the Equimarginal Principle. The ideais to make two things equal “at the margin” — in this case, tomake the marginal productivity of labor equal on the two fields.As we will see, it has many applications in economics. In morecomplicated cases, we will have to generalize the rule carefully. Inthis example, for instance, we are allocating resources betweentwo fields that produce the same output. When the differentareas of production are producing different kinds of goods andservices, it will be more complicated. But a version of theEquimarginal Principle will still apply.
Notes
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13.1 Theory of the FirmIn developing the supply and demand approach to economics,economists first worked out the basis of the demand curve. Bytreating the demand for a product or service as a rationaldecision by a (primarily) self-interested individual or family,economists were able to understand the relation of the demandfor one product or service to the demands for other productsand services and to many other forms of economic activity. Itwas natural to apply the same approach to supply. As a firststep, we need to think about the decision-makers in supplyinggoods and services, and what a “rational decision” to supplygoods and services would mean. In economics, this is oftencalled the “Theory of the Firm.”In the remainder of this lesson we will apply the concepts ofmarginal productivity and diminishing returns to the theory ofthe firm. First we will talk a bit about business firms and theirrole in a market economy, then we will return to the marginalproductivity approach.A firm is a unit that does business on it’s own account. (Firm isfrom the Italian, “firma,” a signature, and the idea is that a firmcan commit itself to a contract). Thus, the firm is the decision-maker in supplying goods and services.There are three main kinds of firms in modern market econo-mies:
13.1.1 ProprietorshipsA proprietorship (or proprietary business) is a business ownedby an individual, the “proprietor.” Many “Mom and Popstores” — and other “Mom and Pop” businesses — areproprietorships. Some proprietorships are too small even toemploy one person full time. Craftsmen, such as plumbers andpainters, may have “day jobs” and work as self-employedproprietors part time after hours. Computer programmers andothers may also do that. At the other extreme, some proprietarybusinesses employ many hundreds of workers in a wide rangeof specializations. In a proprietorship, the proprietor is almostalways the decision-maker for the business.
13.1.2 PartnershipsA partnership is a business jointly owned by two or morepersons. In most partnerships, each partner is legal liable fordebts and agreements made by any partner. Of course, thisrequires a great deal of trust, and thus partners generally knowone another well enough to have that sort of trust. Familypartnerships are very common for that very reason. (There arenow a few “limited partnerships” in which some partners areprotected from legal liability for the agreements made by others,beyond some limits). In many cases, one partner is designatedas the managing partner and is the main decision-maker for thebusiness.
LESSON 13:THEORY OF FIRM
13.1.3 CorporationsA corporation has two characteristics that distinguish it frommost proprietorships and partnerships:• Limited liability• Anonymous ownershipLimited liability means that the owner of shares in a corpora-tion cannot lose more than a certain amount if the companyfails. Usually the amount is the money paid to buy the shares.Anonymous ownership means that the owner of the shares cansell them without getting the permission of anyone other thanthe buyer. By contrast, in most partnerships, no one partner cansell out without getting the agreement of the other partners. Insuch a case the continuing partners will, of course, want toknow about the new partner — he will not be an “anonymousowner.” In a typical corporation, the shareholders formally electa board of directors, who in turn select the officers of thecompany. One of these officers, often called the “president,”will be the principle decision-maker for the firm, but he will beexpected to make decisions in the interest of the shareholders.While there are millions of proprietorships, typically very small,the biggest businesses are corporate and corporations areparticularly important because of their size.
13.2 ObjectivesAs we recall, Malthus did not have firms in mind when heformulated the Law of Diminishing Returns. But this law hasapplications Malthus did not envision, and we will see how toapply the law to a business firm. In the Reasonable Dialog ofeconomics in the nineteenth century, the development of theseideas was a bit indirect. In about the eighteen-seventies,economists were rethinking the theory of consumer demand.They applied a version of “diminishing returns” and theEquimarginal Principle to determine how a consumer woulddivide up her spending among different consumer goods.(We’ll get into that in another lesson). That worked pretty well,and so some other economists, especially the Americaneconomist John Bates Clark, tried using the same approach inthe theory of the firm. These innovations were the beginningof Neoclassical Economics.Following the Neoclassical approach, we will interpret “rationaldecisions to supply goods and services” to mean decisions thatmaximize — something! What does a supplier maximize? Theoperations of the firm will, of course, depend on its objectives.One objective that all three kinds of firms share is profits, and itseems that profits are the primary objective in most cases. Wewill follow the neoclassical tradition by assuming that firms aimat maximizing their profits.There are two reasons for this assumption. First, despite thegrowing importance of nonprofit organizations and thefrequent calls for corporate social responsibility, profits still seemto be the most important single objective of producers in our
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market economy. Thus it is the right place to start. Second, agood deal of the controversy in the reasonable dialog ofeconomics has centered on the implications of profit motiva-tion. Is it true, as Adam Smith held, that the “invisible hand”leads profit-seeking businessmen to promote the general good?To assess that question, we need to understand the implicationsof profit maximization.
13.3 ProfitProfit is defined as revenue minus cost, that is, as the price ofoutput times the quantity sold (revenue) minus the cost ofproducing that quantity of output.However, we need to be a little careful in interpreting that.Remember, economists understand cost as opportunity cost —the value of the opportunity given up. Thus, when we say thatbusinesses maximize profit, it is important to include all costs— whether they are expressed in money terms or not.For example, a cab-driver — the self-employed proprietor of anindependent cab service — says: “I’m making a ‘profit,’ but Ican’t take home enough to support my family, so I’m going tohave to close down and get a job.” The proprietor is ignoringthe opportunity cost of her own labor. When those opportu-nity costs are taken into account, we will find that he is not reallymaking a profit after all.Let’s say that the cab-driver makes $500 a week driving his cab,after all expenses (gasoline, maintenance, etc.) have been takenout. Suppose he can get wages (including tips!) of $800 drivingfor someone else, with hours no longer and about the sameconditions otherwise. Then $800 is the opportunity cost of hislabor, and after we deduct the opportunity cost from his $500net as an independent cabbie, he is actually losing $300 perweek.This is one of the most important reasons for using theopportunity cost concept: it helps us to understand thecircumstances that will lead people to get into and out ofbusiness.Because accountants traditionally considered only money costs,the net of money revenue minus money cost is called “account-ing profit.” (Actually, modern accountants are well aware ofopportunity cost and use the concept for special purposes). Theeconomist’s concept is sometimes called “economic profit.” Ifthere will be some doubt as to which concept of profit wemean, we will sometimes use the terms “economic profit” or“accounting profit” to make it clear which is intended.
13.4 The John Bates Clark ModelLike any other unit, a firm is limited by the technology available.Thus, it can increase its outputs only by increasing its inputs. Asusual, this will be expressed by a production function. Theoutput the firm can produce will depend on the land, labor andcapital the firm puts to work.In formulating the Neoclassical theory of the firm, John BatesClark took over the classical categories of land, labor and capitaland simplified them in two ways. First, he assumed that alllabor is homogenous — one labor hour is a perfect substitutefor any other labor hour. Second, he ignored the distinctionbetween land and capital, grouping together both kinds of
nonhuman inputs under the general term “capital.” And heassumed that this broadened “capital” is homogenous.Of course, the simplifying assumptions aren’t true — JohnBates’ Clark’s conception of the firm is highly simplified, like amap at a very large scale. In more advanced economics, we canget rid of the simplifying assumptions and deal with a muchmore realistic “map” of the business firm. But for most of thisbook, we’ll take that on faith, and stick to the simplified versionClark gave us. That will make it simpler, and the principles wewill discover are sound and applicable to the real world in all itscomplexity.In the John Bates Clark model, there are some importantdifferences between labor and capital, and they relate to the longand short run.
13.4.1 Short and Long RunA key distinction here is between the short and long run.Some inputs can be varied flexibly in a relatively short period oftime. We conventionally think of labor and raw materials as“variable inputs” in this sense. Other inputs require a commit-ment over a longer period of time. Capital goods are thoughtof as “fixed inputs” in this sense. A capital good represents arelatively large expenditure at a particular time, with theexpectation that the investment will be repaid — and any profitpaid — by producing goods and services for sale over the usefullife of the capital good. In this sense, a capital investment is along-term commitment. So capital is thought of as beingvariable only in the long run, but fixed in the short run.Thus, we distinguish between the short run and the long run asfollows:In the perspective of the short run, the number and equipmentof firms operating in each industry is fixed.In the perspective of the long run, all inputs are variable andfirms can come into existence or cease to exist, so the numberof firms is also variable.
13.4.2 AssumptionsThe John Bates Clark model of the firm is already prettysimple. We are thinking of a business that just uses two inputs,homogenous labor and homogenous capital, and produces asingle homogenous kind of output. The output could be aproduct or service, but in any case it is measured in physical (notmoney) units such as bushels of wheat, tons of steel orminutes of local telephone calls. In the short run, in addition,the capital input is treated as a given “fixed input.” Also, we canidentify the price of labor with the wage in the John Bates Clarkmodel. (In a modern business firm, we have to include benefitsas well as take-home wages. The technical term for the total,wages and benefits, is “employee compensation.”)We will add two more simplifying assumptions. The newsimplifying assumptions are:• The price of output is a given constant.• The wage (the price of labor per labor hour) is a given
constant.Putting them all together — just two kinds of input and onekind of output, one kind of output fixed in the short run, andgiven output price and wage — it seems to be a lot of simplify-
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ing assumptions, and it is. But, as we will see in later lessons ofthe book, these are not arbitrary simplifying assumptions. Theyare the assumptions that fit best into many applications, andthe starting point for still others.Once we have simplified our conception of the firm to thisextent, what is left for the director of the firm to decide.
13.5 The Firm’s DecisionIn the short run, then, there are only two things that are notgiven in the John Bates Clark model of the firm. They are theoutput produced and the labor (variable) input. And that is notactually two decisions, but just one, since labor input andoutput are linked by the “production function.” Either• the output is decided, and the labor input will have to be
just enough to produce that outputor
• the labor input is decided, and the output is whatever thatquantity of labor can produce.
Thus, the firm’s objective is to choose the labor input andcorresponding output that will maximize profit.Let’s continue with the numerical example in previous lesson.Suppose a firm is producing with the production functionshown there, in the short run. Suppose also that the price ofthe output is $100 and the wage per labor-week is $500. Thenlet’s see how much labor the firm would use, and how muchoutput it would produce, in order to maximize profits.The relationship between labor input and profits will looksomething like this:
Figure 13.1: Labor Input and ProfitsIn the figure, the green curve shows the profits rising and thenfalling and the labor input increases. Of course, the eventualfall-off of profits is a result of “diminishing returns,” and theproblem the firm faces is to balance “diminishing returns”against the demand for the product. The objective is to get tothe top of the profit hill. We can see that this means hiringsomething in the range of four to five hundred workers for theweek. But just how many?The way to approach this problem is to take a bug’s-eye view.Think of yourself as a bug climbing up that profit hill. Howwill you know when you are at the top?
13.6 The Marginal ApproachThe bug’s-eye view is the marginal approach. However muchlabor is being employed at any given time, the really relevantquestion is, supposing one more unit of labor is hired, willprofits be increased or decreased? If one unit of labor iseliminated, will profits increase or decrease? In other words,
what does one additional labor unit add to profits? Whatwould elimination of one labor unit subtract from profits?We can break that question down. Profit is the difference ofrevenue minus cost. Ask, “What does one additional labor unitadd to cost? What does one additional labor unit add torevenue?The first question is relatively easy. What one additional laborunit will add to cost is the wage paid to recruit the one addi-tional unit.The second question is a little trickier. It’s easier to answer arelated question: “What does one additional labor unit add toproduction?” By definition, that’s the marginal product — themarginal product of labor is defined as the additional output asa result of increasing the labor input by one unit. But we need ameasurement that is comparable with revenues and profits, thatis, a measurement in money terms. Since the price is given, themeasurement we need is the Value of the Marginal Product:
Value of the Marginal ProductThe Value of the Marginal Product is the product of themarginal product times the price of output. It is abbreviatedVMP.To review, we have made some progress toward answering theoriginal question. Adding one more unit to the labor input, wehave
increase in revenue = value of marginal productincrease in cost = wage
So the answer to “What will one additional labor unit add toprofits?” is “the difference of the Value of the Marginal ProductMinus the wage.” Conversely, the answer to “What will theelimination of one labor unit add to profits?” is “the wageminus the Value of Marginal Product of Labor.” And in eithercase the “addition to profits” may be a negative number: eitherbuilding up the work force or cutting it down can drag downprofits rather than increasing them.So, again taking the bug’s-eye view, we ask “Is the Value of theMarginal Product greater than the wage, or less?” If greater, weincrease the labor input, knowing that by doing so we increaseprofits by the difference, VMP-wage. If less, we cut the laborinput, knowing that by doing so we increase profits by thedifference, wage-VMP. And we continue doing this until theanswer is “Neither.” Then we know there is no further scope toincrease profits by changing the labor input — we have arrivedat maximum profits.Let’s see how that works. Let’s go back to the numericalexample from earlier in the lesson, and assume that the price ofoutput is $100 per unit and the wage is $500. In Figure 8,below, we have the value of the marginal product, $100*MP,and the wage for that example.
Figure 13.2Now suppose that the firm begins by using just 200 units of
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“If I were to increase the labor input to 201, that would increaseboth costs and revenues. By how much? Let’s see: the VMP is850, so the additional worker will add $850 to revenues. Sincethe wage is $500, the additional worker will add just $500 tocost, for a net gain of $350. It’s a good idea to “upsize” andadd one more worker.On the other hand, suppose that the firm is using 800 units oflabor, as shown by the other orange line. The manager asksherself, “If I were to cut the labor input to 799, that would cutboth costs and revenues. By how much? Let’s see: the VMP is200, so the additional worker will add just $200 to revenues.Since the wage is $500, the additional worker will add just $500to cost, for a net loss of $300. It’s time to “downsize” and cutthe labor force.In each case, there is an unrealized potential, and the amount ofunrealized potential is the difference between the VMP and thewage. The firm’s profit potential will not be 100% realized untilthe VMP is equal to the wage. That’s the “equimarginalprinciple” again.
13.7 The Equimarginal PrincipleBy taking the marginal approach — the bug’s-eye view — wehave discovered the diagnostic rule for maximum profits. Theway to maximize profits then is to hire enough labor so that
VMP=wagewhere p is the price of output and VMP = p*MP the marginalproductivity of labor in money terms.This is another instance of the Equimarginal Principle. The ruletells us that profits are not maximized until we have adjustedthe labor input so that the marginal product in labor, in dollarterms, is equal to the wage. Since the wage is the amount thatthe additional (marginal) unit of labor adds to cost, we couldthink of the wage as the “marginal cost” of labor and expressthe rule as “value of marginal product of labor equal tomarginal cost.” But we will give a more compete and carefuldefinition of marginal cost (of output) in the next lesson.
13.8 Profit MaximizationIn our numerical example, suppose that the price of output is$100 per unit and the wage is $500 per worker per period. Thenthe p*MP, wage, and profits will be something like this:Table 13.1
Labor Marginal Productivity
p*MP Wage Accounting Profit
0 9.45 945 500 0 100 8.35 835 500 44500 200 7.25 725 500 78000 300 6.15 615 500 100500 400 5.05 505 500 112000 500 3.95 395 500 112500 600 2.85 285 500 102000 700 1.75 175 500 80500 800 0.65 65 500 48000 900 -0.45 -55 500 4500
1000 500 -50000
What we see in the table is that the transition from 400 to 500units of labor gives p*MP=505, very nearly VMP=wage. Andthat is the highest profit. So the profit-maximizing labor forceis about 500 units.
We can get a more exact answer by looking at a picture. Here is apicture of the profit-maximizing hiring in this example:
Figure 13.3: Maximizing ProfitThe picture suggests that the exact amount is a bit less than 500units of labor. The exact number is 454.54545454545 ... unitsof labor — a repeating decimal fraction.Notice the shaded area between the VMP curve and the price(wage) line. n the picture, the area of the shaded triangle is thetotal amount of payments for profits, interest, and rent — inother words, everything the firm pays out for factors ofproduction other than labor. The rectangular area below thewage line and left of the labor=454 line is shows the wage bill.Thus, the John Bates Clark model provides us with a visualiza-tion of the division of income between labor and property.We’ll make use of this fact in exploring the economics ofincome distribution in the last Part of this lesson.We can use the diagram also to understand why VMP=wage isthe diagnostic that tells us the profit is at a maximum. Supposethe labor input is less than 500 — for example, suppose laborinput is 200. Than an additional labor-day of labor will addabout 7.8 units to output, and about $780 to the firm’s salesrevenue, but only $500 to the firm’s costs, adding roughly $220to profits. So it is profitable to increase the labor input from200, or, by the same reasoning, from any labor input less than$500.This difference between the VMP and the wage is the increase ordecrease in profits from adding or subtracting one unit oflabor. It is sometimes called the marginal profit and (as weobserved in studying consumers’ marginal benefits) theabsolute value of the marginal profits is a measure of unreal-ized potential profits. That’s why the businessman wants toadjust the labor input so that VMP-wage=0.Let’s try one more example. Suppose the labor input is 800labor-days per week. If the firm “downsizes” to 799 labor-days,it reduces its output by just about 1.2 units and its sales revenueby about $120, but it reduces its labor cost by $500, increasingprofits by about $380. Thus a movement toward theVMP=wage again increases profits by realizing some unrealizedpotential profit.The formula VMP=wage is a diagnostic for maximum profitsbecause it tells us that there is no further potential to increasethe profits by adjusting the labor input — marginal profit iszero.The marginal productivity rule is the key to maximization ofprofits in the short run. But now let’s take a look at the longrun perspective.
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13.8 Increasing Returns to Scale and the Long RunIn microeconomics, we think of diminishing returns as a shortrun thing. In the long run, all inputs can be increased ordecreased in proportion. Reductions in the marginal productiv-ity of labor, due to increasing the labor input, can be offset byincreasing the tools and equipment the workers have to workwith. How will that come out, on net? The answer is — “it alldepends!”In the long run we define three possible cases:
Decreasing returns to scaleIf an increase in all inputs in the same proportion k leads to anincrease of output of a proportion less than k, we havedecreasing returns to scale. Example: If we increase the inputsto a dairy farm (cows, land, barns, feed, labor, everything) by50% and milk output increases by only 40%, we have decreasingreturns to scale in dairy farming. This is also known as“diseconomies of scale,” since production is less cheap whenthe scale is larger.
Constant returns to scaleIf an increase in all inputs in the same proportion k leads to anincrease of output in the same proportion k, we have constantreturns to scale. Example: If we increase the number ofmachinists and machine tools each by 50%, and the number ofstandard pieces produced increases also by 50%, then we haveconstant returns in machinery production.
Increasing returns to scaleIf an increase in all inputs in the same proportion k leads to anincrease of output of a proportion greater than k, we haveincreasing returns to scale. Example: If we increase the inputs toa software engineering firm by 50% output and increases by60%, we have increasing returns to scale in software engineering.(This might occur because in the larger work force, someprogrammers can concentrate more on particular kinds ofprogramming, and get better at them). This is also known as“economies of scale,” since production is cheaper when the scaleis larger.In introductory economics, we usually discuss these long runtendencies in the context of cost analysis, rather than marginalproductivity analysis. However, increasing returns to scale, inparticular, creates some complications for the application ofmarginal productivity thinking. Thus, I think there may besomething to gain by exploring how increasing returns to scalegoes together with marginal productivity. To keep it as simple aspossible, we will look at a numerical example of a two-personlabor market and a fictitious product that is produced withincreasing returns to scale. Economists often like to talk aboutthe production of “widgets,” so our fictitious industry is thewidget-tying industry.
13.8.1 Example of Production with Increasing Returns toScale
Assumptions:
• Since this is a long run analysis, there is no fixed input.Indeed, for simplicity, there is only one input. Labor is theonly input and is variable.
• Our small economy is populated by three people: Bob andJohn, workers, and Gordon, an entrepreneur (that is, aperson who will organize a business if and only if it isprofitable to do so).• Bob, working alone, can produce output worth 2000 per
week.• Bob’s opportunity cost is 2100 per week. (That means
Bob can earn 2100 in producing some other good orservice).
• John, working alone, can produce 2000 per week.• John’s opportunity cost is 2800 per week.
• If Bob and John work together, thanks to division oflabor, they can produce 5500 per week. Suppose, for example,that Gordon sets up a Widget-Tying business and hires Boband, later, John to do the work. This is an example of “increas-ing returns to scale” since input increases by 100% when thesecond worker is hired and output increases by 175% as a result.Why would output increase more than in proportion toinputs? First, simply having four hands may increase productiv-ity as the two men can simultaneously do different parts of thejob. Second, each may concentrate on some part of the work,getting better at it with more practice, but leaving the other partto the other worker who also gains practice and skill in that part.(These were the kinds of advantages Adam Smith particularlystressed). Finally, each may concentrate on the tasks for which hehas a greater inborn talent.Notice that the two-person widget-tying operation usesresources with an opportunity cost of 2800+2100=4900 andproduces output worth 5500, for a net increase in productionof 600. Evidently, it is a good thing that such a team beorganized.
13.8.2 The Dark Side of the ForceIncreasing returns to scale are a powerful force for increasingproductivity, but the problem of organizing them efficiently is“the dark side of the force.” We have seen that an enterprisethat yields a net gain of 600 to society cannot be organized, inthis example, without producing a loss. The market systemcannot take advantage of the potentiality for gain throughdivision of labor and increasing returns to scale in this case.This possibility was discovered by an early 20th Century Britisheconomist named Arthur Charles Pigou, but despite 80 years ofdiscussion, this analysis is not at all widely understood, evenamong professional economists. Pigou thought it might be agood idea for the government to subsidize enterprises withincreasing returns to scale. In this case a subsidy of 150 wouldmake the widget-tying enterprise profitable and produce a gainof 600 in national product.There may be another solution. Since the widget-tying enter-prise adds 600 to national output but loses at least 100, wemight ask, what happens to the difference of 700? The answeris that Bob gets it. Bob is paid at least 2800 but his opportunitycost is only 2100, accounting for the difference of 700. Supposethat Bob and John were not paid the same wage, but, instead,each was paid his opportunity cost plus 100. The wage billwould then be 2200+3000=5200 and Gordon would finishwith a profit of 300. Thus, wage discrimination may make it
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possible for the widget-tying enterprise to exist when it cannotexist so long as each worker is paid the same wage for the samework.The conclusions are surprising, and understandably, controver-sial — yet the numbers support them, both in this and morecomplicated and abstract examples.1. Some people believe it is just that each person be paid
according to her or his contribution, and interpret “marginalproductivity” as the person’s contribution. However, thismay impossible when there are increasing returns to scale, asthere may not be enough output to pay everyone on thatbasis.
2. Compromising, some would say that each person ought tobe paid in proportion to her or his contribution, so thatpeople are paid equally for the same work. That, too, may beimpossible.
3. Discrimination or subsidy may be necessary to allow somesocially useful activities to exist.
4. There may be no simple system of payment (such as supplyand demand or equal pay for equal work) that will allow asocially useful enterprise with increasing returns to scale toexist.
I think this is the reason we have organizations. If there wereno increasing returns to scale, there would be little reason forany business to employ more than one person. We wouldinstead have an economy consisting of self-employed individu-als, like a yeoman agricultural system. Instead we see aneconomic system consisting in part of large, complicatedorganizations with internal arrangements and paymentssystems that have little to do with contributions or marginalproductivity, and may be discriminatory. From an abstract pointof view, they may waste resources by not paying at the marginalproductivity; but the benefits of increasing returns to scale areso great that, even falling far short of potential efficiency, theycan still be very productive.This is sometimes lost sight of by the organizations them-selves. People naturally avoid complexity, and organizationssometimes try to set up simple, market-like internal paymentand fund transfer systems, hoping that this will increaseefficiency. But, as we have seen, this can fail badly in the contextof increasing returns to scale (and that is the context of anylarge productive organization). We have recently been throughsuch an experience at Drexel. A few years ago we went over to“revenue centered budgeting.” The idea was to let the collegesretain a high proportion of the revenues they produce, throughtuition, grants, contracts and so on. This would (it was felt) givethe deans and college faculties more “incentive” to set uppopular new programs and initiatives. However, it wasn’tpossible to let the colleges keep 100%, since some money isneeded to run shared services like the computer center, student-life activities, and the library, not to mention the salaries of highadministrators (and we wouldn’t think of mentioning that).But it couldn’t be made to work. If the proportion kept by thecolleges was high enough to make it profitable for them to setup new programs and initiatives, there was not enough for thepurposes of the central administration; while if the proportiontaken by the central administration was enough to do its job,
then the colleges were losing money on their new programs andinitiatives — no incentive! So Drexel has moved away from“revenue centered budgeting” in practice, although there is stillsome work being done to try to work out a “revenue centeredbudgeting” system that will work. Here’s a prediction based onthe theory of increasing returns to scale: a revenue-centeredbudgeting system probably can be made to work, but it will bejust as complex and frustrating than the centralized budgetingtraditionally has been. That complexity and frustration (andlarge organizations) are the price we pay for the benefits ofincreasing returns to scale.
13.9 SummaryWe have seen that the concept of marginal productivity and thelaw of diminishing marginal productivity play central parts inboth the efficient allocation of resources in general and in profitmaximization in the John Bates Clark model of the businessfirm.The John Bates Clark model and the principle of diminishingmarginal productivity provide a good start on a theory of thefirm and of supply. In applying the marginal approach and theequimarginal principle to profit maximization, it extends ourunderstanding of the principles of efficient resource allocation.Some key points in the discussion have been• the distinction between marginal productivity and average
productivity• the “law of diminishing marginal productivity”• the rule for division of a resource between two units
producing the same product: equal marginal productivities• the diagnostic formula VMP=wage, that tells us the input
and output are adjusted to maximize profits in the businessfirm, in the short run
• In the long run, there may be increasing, decreasing, orconstant returns to scale. Increasing returns to scale willcomplicate things somewhat for the marginal productivityapproach.
This has given us a start on the theory of the business firm.But we will want to reinterpret the model of the firm in termsof cost — since the cost structure of the firm is important initself, and important for an understanding of supply.
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LESSON 14:APPLICATIONS OF THEORY OF PRODUCTION
Production: the creation of any good or service that haseconomic value to either consumers or other producers.Production analysis focuses on the efficient use of inputs tocreate outputs. The process involves all of the activitiesassociated with providing goods and services.
Managerial Questions:
1. Whether to produce or shut down2. How much to produce3. What input combination to use4. What type of technology to use
Examples:
a. physical processing or manufacturing of material goodsb. production of transportation servicesc. production of legal adviced. production of educatione. production of invention (R & D)f. production of bank loansProduction Function: a mathematical model relating themaximum quantity of output that can be produced from givenamounts of various inputs.
ora schedule (table, equation) showing the maximum amount ofoutput that can be produced from any specified set of inputs,given the existing technology or “state of the art.”In short — the production function is a catalog of outputpossibilities.
Q = f (X,Y) or (K,L)
Economic Efficiency:The production function incorporates the technically efficientmethod of production — the latest technological processes areused. When economists use production functions they assumethat the maximum level of output is obtained from any givencombination of inputs; that is, they assume that production istechnically efficient.When producers are faced with input prices, the problem is nottechnical but economic efficiency: how to produce a givenamount of output at the lowest possible cost. To be economi-cally efficient, a producer must determine the combination ofinputs that solves this problem.What then is technical inefficiency? If, for example, an alterna-tive process can produce the same amount of output using lessof one or more inputs and the same amounts of all others,then the first process is technically inefficient.If, however, the second process uses less of some inputs butmore of others, the economically efficient method of produc-
ing a given level of output depends on the prices of the inputs.One might cost less but actually be less technically efficient.
Classifying Inputs:Fixed: a fixed input is one that is required in the productionprocess. The amount of the fixed input employed is constantover a given period of time regardless of the quantity ofoutput produced.Variable Input: one whose quantity employed in the produc-tion process is varied, depending on the desired quantity ofoutput to be produced.
Time Frames:
Short-Run: a period of time in which one or more of theinputs is fixed.Very Short-Run: all resources are fixed.Long Run: time period long enough that all resources can bevaried.
Ore mining example
Output = tons or ore minedCapital (horsepower)
Labor 250 500 750 1,000 1,250 1,500 1,750 2,000 1 1 3 6 10 16 16 16 13 2 2 6 10 24 29 29 44 44 3 4 16 29 44 55 55 55 50 4 6 29 44 55 58 60 60 55 5 16 43 55 60 61 62 62 60 6 29 55 60 62 63 63 63 62 7 44 58 62 63 64 64 64 64 8 50 60 62 63 64 65 65 65 9 55 59 61 63 64 65 66 66
10 52 56 59 62 64 65 66 67
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Labor Output MP ∆Q ÷ ∆X
AP (Q ÷ X)
Elasticity MP ÷ AP
0 0 1 6 +6 6 1.0 2 16 +10 8 1.25 3 29 +13 9.67 1.34 4 44 +15 11 1.36 5 55 +11 11 1.0 6 60 +5 10 .50 7 62 +2 8.86 .23 8 62 0 7.75 0.0 9 61 -1 6.78 - .15
10 59 -2 5.90 - .34
Returns to Scale: The relation between output and variationin all inputs taken together.Returns to factor: The relation between output and variationin only one of the inputs employed.Total Product: The total output that results from employing aspecific quantity of resources in a production system.Marginal Product: the incremental change in total output thatcan be produced by the use of one more unit of the variableinput in the production process.
-or-The change in output associated with a unit change in one inputfactor, holding other inputs constant.∆Q change brought about by a change in∆X units of the variable inputY remains fixed
? X? QMPx =
-or, in continuous terms:
XQMPx ∂
∂=
Average Product
XQAPx =
the ratio to total output to the amount of the variable inputused in producing the output.
Production Elasticity:
The percentage change in output resulting from a givenpercentage change in the amount of the variable input Xemployed in the production process with Y remaining constant.
-or-The percentage change in output associated with a 1 (one)percent change in all inputs.
Ex = %∆Q%∆X
= ∆Q/Q∆X/X
Rearranging Terms —=
∆Q/∆XQ/X
= MPxAPx
Law of Diminishing Marginal Returns:The use of increasing amounts of a variable factor in a produc-tion process beyond some point, given the amount of all other
production factors remains unchanged, will eventually result indiminishing marginal returns in total output.This observation is easily verified by reviewing the slope of themarginal product curve.As the number of units of the variable input increases, otherinputs held constant, there exists a point beyond which themarginal product of the variable input declines.Note:
a) not a mathematical theoremb) empirical assertion
Summary: The concepts of total and marginal product and thelaw of diminishing returns to a factor are important in identify-ing efficient as opposed to inefficient input combinations.
Determining the optimal use of the variable inputWith one of the inputs (Y) fixed in the short run, the producermust determine the optimal quantity of the variable input (X)to employ in the production process.This is a study of Marginal Revenue Product (MRP) andMarginal Factor Cost (MFC). That is, this is a study about therole of revenue and cost in the production system.
MRPThe conversion from physical to economic relations is accom-plished by multiplying the MP of input factors by the MRresulting from the sale of goods or services produced to obtaina quantity known as the Marginal Revenue Product of input:Def: the amount that an additional unit of the variable inputadds to total revenue, -or-The economic value of a marginal unit of a particular inputfactor when used in the production of a specific product.
MRP = ∆TR∆X
where ∆TR is the change in total revenue associated with thegiven change (∆X) in the variable input.MRPx is equal to the marginal product of X (MPx) times themarginal revenue (MRQ) resulting form the increase in outputobtained:
MRP = MPX . MRQ
Example
Units TP MP MR at $5 1 3 3 $15 2 7 4 20 3 10 3 15 4 12 2 10 5 13 1 5
If the addition of one more laborer to a work force wouldresult in the production of two incremental units of a productthan can be sold for $5, the MP of labor is 2, and its MRP is$10 (2 x $5).
Marginal Factor CostDef: MFC is the amount that an additional unit of the variableinput adds to total cost
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MFC = ∆TC
∆X
Optimal Input Level
Given the marginal revenue product and marginal factor cost,we can compute the optimal amount of the variable input touse in the production process.Recall that prior discussions on optimality and marginal analysissuggest that an economic activity should be expanded as long asthe marginal benefits exceed the marginal costs. The optimalpoint occurs at the point where the marginal benefits are equalto the marginal costs.
MRPX = MFCX
Single Input SystemProfit maximization requires production at a level such thatmarginal revenue equals marginal cost. Because the only variablein the system is input L, the marginal cost of production is:
MC = ∆TC∆Output
MC = PL
MPL
Since marginal revenue must equal marginal cost at the profit-maximizing level, MRQ can be substituted for MCQ
MRQ = PL
MPL
solving for PL yields:PL = MRQ x MPL
-or-PL = MRPL
The profit maximizing firm will always employ an input up tothe point where its marginal revenue product equals its cost.Note : if MRPL > PL the expand labor usage.
if MRPL < PL the cutback labor usage.
The Ore-Mining Example Revisited
1. Firm can employ as much labor as it needs by paying workers$50 per period (the labor market is considered perfectlycompetitive).
2. Firm can sell all the ore it can produce at a price of $10 perton.MRP = MFC = $50
3. At less than 6 workers, MRP > MFC and the addition ofmore workers will increase revenues. Beyond 6, the oppositeis true.
Labor Input Total Prod. Tons of Ore
MP of Labor
TR or P • Q MR ∆∆TRQ
MRP
MP•MR MFC
0 0 0 1 6 6 60 10 60 50 2 16 10 160 10 100 50 3 29 13 290 10 130 50 4 44 15 440 10 150 50 5 55 11 550 10 110 50 6 60 5 600 10 50 50 7 62 2 620 10 20 50 8 62 0 620 10 0 50
Production functions with 2 variable inputsUsing the Ore Mining example, assumed that both capital andlabor are now variable.
Production IsoquantA production isoquant is either a geometric curve or an algebraicfunction representing all the various combinations of the twoinputs that can be used in producing a given level of output, -or-An isoquant is a curve (a locus of points) showing all possiblecombinations of inputs physically capable of producing a givenfixed level of output.
Marginal rate of technical substitutionDef: the rate at which one input may be substituted for anotherinput in the production process, -or-the rate at which one input is substituted for another along anisoquant.The rate of change of one variable with respect to anothervariable is given by the slope of the curve relating the twovariables. Thus, the rate of change of input Y with respect to X— that is, the rate at which Y may be substituted for X in theproduction process — is given by the slope of the curve relatingY to X. This is the slope of the isoquant.Since the slope is negative and one wishes to express thesubstitution rate as a positive quantity, a negative sign isattached to the slope.
MRTS = Y1 - Y2X1 - X2
= ∆Y
∆X
For example, in the Ore Mining problem, moving from 3 to 4workers yields an MRTS of 250 (horsepower).
MRTS = - 750-500
3-4 = 250
Stated differently, for every unit of labor added 250 horsepowermay be discharged without changing total output.Note that we can show the MRTS to equal the ratio of themarginal products of X and Y; remember:
∆Y = ∆Q
MPYand,
∆X = ∆Q
MPX
substituting these in above yields,
MRTS = MPXMPY
The optimal combination of inputsThe firm must make two input choice decisions:1. Choose the input combination that yields the maximum
level of output possible with a given level of expenditure.2. Choose the input combination that leads to the lowest cost
of producing a given level of output.This occurs when, in any constrained optimization problem, wechoose the level of each activity whereby the marginal benefits
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from the last unit of each activity per dollar cost of the activityare equal. This is known as the equimarginal criterion.
MPXCX
= MPYCY
-or-MPXPX
= MPYPY
The optimal combination of inputs in either the cost-minimi-zation or output-maximization problem is a function of therelative prices of the inputs.
Changes in input pricesAssume that a firm is producing with the most cost minimiz-ing combination of labor and capital. This is an efficientoperation. From our development above, we know that:
MPXCX
= MPYCY
Now suppose that the price of input X rises while the price ofinput Y is unchanged and the original combination of inputsMPX and MPY are unchanged. At the original combinations,the increase in CX makes:
MPXCX
< MPYCY
Substitution Effect:If the firm wishes to produce the same level of output, it willincrease Y and decrease X as it moves along the isoquant.If the input-price ratio changes, firms substitute toward theinput that becomes relatively less expensive and away form theinput that becomes relatively more expensive. In the case oflabor and capital, if wages/interest increases (decreases), K/Lincreases (decreases) at each level of output. This change in theK/L ratio is called the substitution effect.
Isoquant and Isocost CombinationsOptimal input proportions can be found graphically for a two-input, single-output system by adding a budget line or isocostcurve (a line of constant costs) to the diagram of productionisoquants.Each point on a budget line represents some combination ofinputs (X and Y) whose cost equals constant expenditure.
The expansion path is the optimal input combinations forincreasing output. Note that the proportions in which theinputs are combined need not be the same for all levels ofoutputs. Stated differently, the expansion path shows how factorproportions change when output changes, with the factor-price ratioheld constant.
The Decision Making Principle:To minimize the cost (expenditure) of producing a given levelof output with fixed input prices, the producer must combineinputs in such quantities that the marginal rate of technicalsubstitution of capital and labor is equal to the input ratio (theprice of labor to the price of capital).
Returns to scaleProduction theory also offers a means for analysis of the effectson output of changes in the scale of production.An increase in the scale of production consists of a simultaneousproportionate increase in all the inputs used in the productionprocess. The proportionate increase in the output of theproduction process that results from the given proportionateincrease in all the inputs is defined as the physical returns toscale.
εQ = %∆Q%∆X
= ∂Q∂X
• XQ
εQ > 1 increasingεQ = 1 constantεQ < 1 diminishing1. Increasing: Output goes up proportionately more than the
increase in input usage.2. Constant: Output goes up by the same proportion as the
increase in input usage.3. Decreasing: Output goes up proportionately less than the
increase in input usage.
Estimation of production functionsOne of the more common approaches utilizes the CobbDouglas production function method.
21KaLQ ρρ=
1. Both inputs are required to create output.2. MRTS will diminish as required by production theoryLogarithmic SpecificationLn Q = Ln α + β1LnL + β2LnKElasticity of Production
EL = MPLAPL
where;
and,KLaMP 211L
1 ρρρ −
=
21 ß1ß21
KaLLKaL
APL −ρρ
==
thus
ß1KaLKLaß
E ß21ß
21-11
L 1== −
ρρ
The Exponents - Returns to Scale1. Increasing: β1 + β2 > 12. Constant: β1 + β2 = 13. Decreasing: β1 + β2 < 1ExampleQ = 1.010.75 K0.25
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Q was an index of physical volume of manufacturing; L was anindex of the average number of employed wage earners only(that is, salaried employees, officials, and working proprietorswere excluded); and K was an index of the value of plants,buildings, tools and machinery reduced to dollars of constantpurchasing power.The sum of the exponents were restricted to one (constantreturns to scale).
Later Studies by Cobb and Douglas
Q = .84 L0.63 K0.30
A one (1) percent increase in labor input results in about a 2/3percent increase in output, and a one (1) percent increase incapital input results in approximately a 1/3 percent increase inoutput.The sum of the exponents is slightly less than one (1). Seemsto indicate the presence of decreasing returns to scale, however,the sum is not significantly different from 1.0; hence, it reallyconfirms constant returns to scale.
A Three Variable Model
321 KLaLQ nρρρ
ρ=Q is the value added by production plants over 18 industriesLn is non-production work-yearsLp is production work-hoursK is gross book values of depreciable and depletable assetsEmpirical Estimation of a Production Function for: MajorLeague Baseballby CE. Zech as published in the American EconomistIn an attempt to quantify the factors that contribute to theteam’s success, a Cobb-Douglas production function wasdeveloped using data from the 26 major league baseball teamsin 1977. Output (Q) was measured by team victories. Inputsfrom five different categories were included in the model:• Hitting: batting average and power (home runs)• Running: stolen base record• Defense: fielding percentage and total chances accepted• Pitching: earned run average (ERA) and strikeouts-to-walks
ratio.• Coaching: Lifetime won-lost record and number of years
spent managing in the major leagues.• Dummy: NL = 0, AL = 1
Variable Eq. 1 Eq. 2 Eq. 3 Eq. 4 Constant .017 .018 .010 .008 Dummy -.002 -.003 .004 .003 B avg 2.017 1.986 1.969 1.927 HomeRuns .229 .299 .208 .215 Stolen Bases .119 .120 .110 .112 Strikeouts/Walks .343 .355 .324 .334 TotField Chances 1.235 1.200 Field % 5.62 5.96 Mngr.W/L -.003 - .004 Mngr. Years -.004 -.004
R2 .789 .790 .773 .774
Findings:
1. Hitting average contributes almost six times as much aspitching to a team’s success. Contradict traditional wisdom?
2. Home runs contribute about twice as much as stolen basesto a team’s success.
3. Coaching skills are not significant in any of the regressionequations.
4. Defensive skills are not significant in any of the regressionequations.
The sums of the statistically significant variables in each of thefour equations range from 2.588 to 2.709. Because these are allgreater than 1.0, the baseball production functions exhibitincreasing returns to scale.
Notes
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15.1 Introduction to CostWe can look at the business firm from at least two points ofview: productivity, inputs, and outputs (as we have just done)or outputs and costs. In advanced microeconomics, these twopoints of view are called “duals.” They are equally valid, butthey point up different things. They are also opposites from acertain point of view — the higher the productivity, the lowerthe costs. By looking at the firm from the point of view ofcosts, we shift our perspective somewhat, and gain a muchmore direct understanding of supply.We also look more directly at the difference between the longand short run. In the short run, we have two major categoriesof costs:• fixed costs, and• variable costsIn the long run, however, all costs are variable. Thus, we muststudy costs under two quite different headings. Costs will varyquite differently in the long run and in the short.
15.2 Fixed & Variable CostVariable costs are costs that can be varied flexibly as conditionschange. In the John Bates Clark model of the firm that we arestudying, labor costs are the variable costs. Fixed costs are thecosts of the investment goods used by the firm, on the ideathat these reflect a long-term commitment that can be recoveredonly by wearing them out in the production of goods andservices for sale.The idea here is that labor is a much more flexible resource thancapital investment. People can change from one task to anotherflexibly (whether within the same firm or in a new job atanother firm), while machinery tends to be designed for a veryspecific use. If it isn’t used for that purpose, it can’t produceanything at all. Thus, capital investment is much more of acommitment than hiring is. In the eighteen-hundreds, whenJohn Bates Clark was writing, this was pretty clearly true. Overthe past century, a) education and experience have become moreimportant for labor, and have made labor more specialized, andb) increasing automatic control has made some machinery moreflexible. So the differences between capital and labor are lessthan they once were, but all the same, it seems labor is stillrelatively more flexible than capital. It is this (relative) differencein flexibility that is expressed by the simplified distinction oflong and short run.Of course, productivity and costs are inversely related, so thevariable costs will change as the productivity of labor changes.Here is a picture of the fixed costs (FC), variable costs (VC) andthe total of both kinds of costs (TC) for the productivityexample in the last unit:
UNIT IIITHE BUSINESS ORGANISATION
CHAPTER 5:ANALYSIS OF COSTS
LESSON15:COST ANALYSIS - I
Figure 15.1Output produced is measured toward the right on the horizon-tal axis. The cost numbers are on the vertical axis. Notice thatthe variable and total cost curves are parallel, since the distancebetween them is a constant number — the fixed cost.
15.3 Opportunity CostWhat is the connection between the distinction we have justmade — fixed vs variable costs — and opportunity cost, the keyconcept in some earlier chapters?In economics, all costs are included — whether or not theycorrespond to money payments. If we have opportunity costswith no corresponding money payments, they are calledimplicit costs. The implicit costs (as well as the money costs)are included in the cost analysis we have just given.There is some correlation between implicit costs and fixed orvariable costs, but this correlation will be different in suchdifferent kinds of firms as
a factory owned by an absentee investor
This is the easiest case to understand. All of the labor coststo the absentee investor are money costs, including themanager’s salary. If the investor has borrowed some of themoney he invested in the factory, then there are some moneycosts of the capital invested — interest on the loan.However, we must consider the opportunity cost of investedcapital as well. The investor’s own money that he has used tobuy the factory is money that she could have invested insome other business. The return she could have gotten onanother investment is the opportunity cost of her ownfunds invested in the business. This is an implicit cost, andin this case the implicit cost is part of the cost of capital andprobably a fixed cost.
a “mom-and-pop” store
A “mom-and-pop” store (family proprietorship orpartnership) is a store in which family members are self-employed and supply most of the labor. Typically, “Mom”and “Pop” don’t pay themselves a salary — they just take
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money from the till when they need it, since it is theirproperty anyway. As a result, there are no money costs fortheir labor. But their labor has an opportunity cost — thesalary or wages they could make working similar hours insome other business — and so, in this case, the implicit costsinclude a large component of variable labor costs.
a large modern corporation
The corporation has relatively few implicit costs, but generallywill have some. All labor costs will be expressed in moneyterms (though benefits and bonuses have to be included),since the shareholders don’t supply labor to the corporationas “Mom and Pop” do in a family proprietorship. It will payinterest to bondholders and dividends to shareholders. Butthe dividends aren’t really a cost item — they include profitsdistributed to the shareholders. Moreover, the typicalcorporation will retain some profits and invest them withinthe business, a “plowback” investment. Conversely,shareholders may take a large part of their payout inappreciation of the stock value — and plowback investmentis one reason for the appreciation. Thus we would say thatthe corporation has a net equity value, that is, that thecorporation “owns” a certain amount of capital that itinvests in its own business (very much like the absenteeowner in the first example). This capital has an opportunitycost, and that opportunity cost is an implicit cost. Thestockholders, who own the corporation, ultimately receive (asdividends or appreciation) both the opportunity cost of theequity capital and any profit left over after it is taken out.
15.4 Unit CostCosts may be more meaningful if they are expressed on a per-unit basis, as averages per unit of output. In this way, we againdistinguish
Average Fixed Cost (AFC)This is the quotient of fixed cost divided by output. In thenumerical example we are using, when output is 4020 (in thetable) fixed cost is 80000, so AFC is 80000/4020=19.9
Average Variable Cost (AVC)This is the quotient of average cost divided by output. In theexample, at an output of 4020 the variable cost is 350000,giving AVC of 350000/4020=87.06.
Average Total Cost (ATC or AC)This is the quotient of total cost divided by output. In theexample, with 4020 of output total cost is 430000, so AC is430000/4020 = 106.96 = 87.06+19.90.Once again, I will illustrate these concepts with the numericalexample of the firm from the previous chapterHere are the average, average variable, and average fixed costs forour example firm.
Table 15.1Q AC AFC AVC945 138 85 531780 101 45 562505 92 32 603120 90 26 64
3625 91 22 694020 95 20 754305 100 19 814480 107 18 894545 117 18 99
Here are the average cost (AC), average variable cost (AVC) andaverage fixed cost (AFC) in a diagram. This is a good representa-tive of the way that economists believe firm costs vary in theshort run.
Figure 15.2Notice how the average fixed costs decline as the fixed costs are“spread over more units of output.” For large outputs,however, average variable costs rise pretty steeply. The idea isthat with a limited capital plant and thus limited productivecapacity — in the short run — costs would rise much morethan proportionately to output as output goes beyond“capacity.” The average total cost, dominated by fixed costs forsmall output, declines at first, but as output increases, fixedcosts become less important for the total cost and variable costsbecome more important, and so, after reaching a minimum,average total cost begins to rise more and more steeply.
13.5 Marginal CostAs before, we want to focus particularly on the marginalvariation. In this case, of course, it is marginal cost. Marginalcost is defined as
As usual, Q stands for (quantity of) output and C for cost, soQ stands for the change in output, while C stands for the
change in cost. As usual, marginal cost can be interpreted as theadditional cost of producing just one more (“marginal”) unitof output.Let’s have a numerical example of the Marginal Cost definitionto help make it clear. Total cost is 280000 for an output of 3120,and it is 33000 for an output of 3625. So we have
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and
so that
for a marginal cost of $99.01 for the next unit produced. Asusual, this is an approximation, and the smaller the change inoutput we use, the better the approximation is.Here is the marginal cost for our example firm, along withoutput and average cost.
Table 15.2
Output Average Cost Marginal
Cost
0 0
9.45
945 137.57
52.91
1780 101.12
59.88
2505 91.82
68.97
3120 89.74
81.30
3625 91.03
99.01
4020 94.53
126.58
4305 99.88
175.44
4480 107.14
285.71
4545 116.61 769.23
Here is a picture of marginal cost for our example firm, togetherwith average cost as output varies.
Figure 15.3
As before, the output produced is measured by the distance tothe right on the horizontal axis. The average and marginal costare on the vertical axis. Average cost is shown by the curve inyellow, and marginal cost in red. Notice how the marginal costrises to cross average cost at its lowest point.
13.6 Maximization of Profit & CostWe can now give another rule for the maximization of profits.The new rule is really just the same rule as we saw before, onlynow we state it in terms of price and costs. It is theequimarginal principle in yet another form.The question is: “I want to maximize profits. How muchoutput should I sell, at the given price?”The answer is: increase output until
p = MCThe point is illustrated by the following table, which extendsthe marginal cost table in an earlier page to show the price andthe profits for the example firm.
Table 15.3
Output Average Cost price profit Marginal
Cost
0 0 100 0
9.45
945 137.57 100 -35503.65
52.91
1780 101.12 100 -1993.60
59.88
2505 91.82 100 20490.90
68.97
3120 89.74 100 32011.20
81.30
3625 91.03 100 32516.25
99.01
4020 94.53 100 21989.40
126.58
4305 99.88 100 516.60
175.44
4480 107.14 100 -31987.20
285.71
4545 116.61 769.23
100 -75492.45
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Notice how profits are greatest (at 32516.25) when the marginalcost is almost exactly equal to the price of $100. This occurs atan output of 3625, with marginal cost at 99.01. The profit-maximizing output would be very slightly more than 3625.
13.7 Supply & CostWe have discovered the principle of supply for the individualfirm.Remember: what is supply? It is the relation between the priceand the quantity that people want to sell. For an individualfirm, that is: the relation between the price and the quantity thefirm wants to sell.So we ask: at a given price, how much will a (profit- maximiz-ing) firm want to sell? The answer: enough so that the price isequal to marginal cost. In other words, the marginal cost curveis the supply curve for the individual firm.
13.8 Shutdown PointAs long as the firm produces something, it will maximize itsprofits by producing “on the marginal cost curve.” But it mightproduce nothing at all. When will the firm shut down?The answer goes a bit against common sense. The firm willshut down if it cannot cover its variable costs. So long as it cancover the variable costs, it will continue to produce.This is an application of the opportunity cost principle. Justbecause fixed costs are fixed, they are not opportunity costs inthe short run — so they are not relevant to the decision to shutdown. Even if the company shuts down, it must pay the fixedcosts anyway. But the variable costs are avoidable — they areopportunity costs! So the firm will shut down it it cannot meetthe variable (short run opportunity) costs. But as long as it canpay the variable costs and still have something to apply towardthe fixed costs, it is better off continuing to produce.It is important not to confuse shut-down with bankruptcy.They are two different things. If a company cannot pay itsinterest and debt payments (usually fixed costs), then it isbankrupt. But that doesn’t mean it will shut down. Bankruptfirms are often reorganized under new ownership, and continueto produce — just because they can cover their variable costs,and so the new owners do better to continue producing than toshut down.
13.9 Long Run CostThus far we have not considered the long run in cost theory. Wewill now think a bit about the long run, using the concept ofaverage cost.We have defined “the long run” as “a period long enough sothat all inputs are variable.” This includes, in particular, capital,plant, equipment, and other investments that represent long-term commitments. Thus, here is another way to think of “thelong run:” it is the perspective of investment planning.So let’s approach it this way: Suppose you were planning tobuild a new plant — perhaps to set up a whole new company— and you know about how much output you will beproducing. Then you want to build your plant so as to producethat amount at the lowest possible average cost.
To make it a little simpler we will suppose that you have to pickjust one of three plant sizes: small, medium, and large. Here’sthe way they look in a picture:Here are the average cost curves for the small (AC1), medium(AC2) and large(AC3) plant sizes:
Figure 15.4If you produce 1000 units, the small plant size gives the lowestcost.If you produce 3000 units, the medium plant size gives thelowest cost.If you produce 4000 units, the large plant size gives you thelowest cost.Therefore, the long run average cost (LRAC) — the lowestaverage cost for each output range — is described by the “lowerenvelope curve,” shown by the thick, shaded curve that followsthe lowest of the three short run curves in each range.More realistically, an investment planner will have to choosebetween many different plant sizes or firm scales of operation,and so the long run average cost curve will be smooth, some-thing like this:
Figure 15.5As shown, each point on the LRAC corresponds to a point onthe SRAC for the plant size or scale of operation that gives thelowest average cost for that scale of operation.
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13.10 Returns to ScaleIn our pictures of long run average cost, we see that the cost perunit changes as the scale of operation or output size changes.Here is some terminology to describe the changes:
increasing returns to scale = decreasing cost
average cost decreases as output increases in the long run
constant returns to scale = constant costs
average cost is unchanged as output varies in the long run
decreasing returns to scale = increasing costs
average cost increases as output increases in the long runHere are pictures of the average cost curves for the three cases:
increasing returns to scale = decreasing cost
Figure 15.6constant returns to scale = constant costs
Figure 15.7decreasing returns to scale = increasing costs
Figure 15.8
3.9.1.1 Increasing Returns to ScaleEconomists usually explain “increasing returns to scale” byindivisibility. That is, some methods of production can only
work on a large scale — either because they require large-scalemachinery, or because (getting back to Adam Smith, here) theyrequire a great deal of division of labor. Since these large-scalemethods cannot be divided up to produce small amounts ofoutput, it is necessary to use less productive methods toproduce the smaller amounts. Thus, costs increase less than inproportion to output — and average costs decline as outputincreases.Increasing Returns to Scale is also known as “economies ofscale” and as “decreasing costs.” All three phrases mean exactlythe same.
13.9.1.2 Constant Returns to ScaleWe would expect to observe constant returns where the typicalfirm (or industry) consists of a large number of units doingpretty much the same thing, so that output can be expanded orcontracted by increasing or decreasing the number of units. Inthe days before computer controls, machinery was a goodexample. Essentially, one machinist used one machine tool todo a series of operations to produce one item of a specific kind— and to double the output you had to double the number ofmachinists and machine tools.Constant Returns to Scale is also known as “constant costs.”Both phrases mean exactly the same.
13.9.1.3 Decreasing Returns to ScaleDecreasing returns to scale are associated with problems ofmanagement of large, multi-unit firms. Again with think of afirm in which production takes place by a large number of unitsdoing pretty much the same thing — but the different unitsneed to be coordinated by a central management. The manage-ment faces a trade-off. If they don’t spend much onmanagement, the coordination will be poor, leading to waste ofresources, and higher cost. If they do spend a lot on manage-ment, that will raise costs in itself. The idea is that the bigger theoutput is, the more units there are, and the worse this trade-offbecomes — so the costs rise either way.Decreasing Returns to Scale is also known as “diseconomies ofscale” and as “increasing costs.” All three phrases mean exactlythe same. In our examples, the LRAC is (more or less roughly) u-shaped,like this:
Figure 15.9
The idea is that:
• for small outputs, indivisibilities predominate, and so longrun average cost declines with increasing output
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• for intermediate outputs, operations can be expandedroughly proportionately, while tendencies to increasing anddecreasing costs — if any — offset one another.
• for large outputs, the problems of managementpredominate, and so long run average cost increases withincreasing output.
• That’s reasonable — but we should recall that it is prettymuch a guess, and may or may not apply in a particular case!
15.10 SummaryBy thinking in terms of cost, rather than productivity, we gainseveral points of understanding of supply:• While total and average cost concepts have their uses, the
most important in the short run is marginal cost.• To maximize profits, the firm will increase output to the
point where marginal cost equals a given price.• Therefore, the marginal cost curve is itself the supply curve,
in the short run.• The firm will shut down, however, if it cannot cover its
variable cost.• We may think of the long run as a perspective of investment
planning.• Long run average cost is the “lower envelope” of all the
short run average cost curves for different plant or firm sizes.• We may observe increasing costs, decreasing costs, or
constant costs as output increases, in the long run — or allthree, depending on output.
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LESSON 16:COST ANALYSIS - II
You have studied some common concepts of cost in previouslesson, now I will take up some other concepts of cost andutility in this lesson.
1. Explicit Costs and Implicit CostsEconomists classify these types of costs: explicit (=accounting)costs, and implicit costs. Explicit costs are out of pocket,obvious kinds of costs, e.g. expenses on books, tuition, as,etc.. Implicit costs are not really expenses you incur, but involveincome or values you are giving up by not doing somethingthat you could have chosen to do. For instance, if you decide togo to school full time instead of working a $20,000 job, you aregiving up earning $20,000. This is your implicit cost. Sampleproblem: Suppose you are running a small business and incurthe following expenses: labor = $80,000; raw materials =30,000; finance charges on a loan = $3,000. You are not payingexplicit rent, because you own the building you are operating in.If you would rent it out, however, you could be earning$12,000. You also estimate your own time to be worth $25,000.What are your expenses?
2. Accounting Vs Economic CostsAccountants have been primarily concerned with measuringcosts for financial reporting purposes. As a result, they defineand measure cost by the historical outlay of funds that takesplace in the exchange or transformation of a resource.
Economists have been mainly concerned with measuring costsfor decision-making purposes. The objective is to determinethe present and future costs (or resources) associated withvarious alternative courses of action.
In calculating the cost to the firm of producing a given quantityof output, economists include some additional costs that aretypically not reflected in financial reports.
• explicit cost are considered by both groups
• implicit costs are considered by economists:
• opportunity cost of time• opportunity cost of capital
Economic Profit = Tot Rev - Exp Cost - Imp Cost
3. Accounting versus Economic ProfitsTo calculate accounting and economic profits we need to knowthe company’s total revenue. Let’s suppose it is $140,000. Then,accounting profits are: total revenue minus explicit costs or:$140,000 - $113,000 = $27,000. Economic profits are: totalrevenue minus total economic costs or; $140,000 - $150,000 = -$10,000 (i.e. a loss of $10,000).
The above firm reaps a positive accounting profit; but thenegative economic profit indicates that from an economic pointof view, the owner should discontinue the operation.
4. Total and Per Unit CostsSeven cost functions which we will discuss are:
1. Total Variable Cost (TVC) – The cost of all variableresourcesExamples: Cost of labor, materials, office supplies
2. Total Fixed Cost (TFC) – The cost of all fixed inputs
Examples: Cost of the building, large pieces of machinery,certain taxes
3. Total Cost (TC) – This the sum of TVC and TFC.
4. Average Variable Cost (AVC) – This is variable cost perproduct.
5. Average Fixed Cost (AFC) – This is fixed cost per product.
6. Average Total Cost (ATC) – This is total cost per product.
7. Marginal Cost (MC) – This is the cost of producing anadditional unit of the product
5. Cost CalculationsUsing the above abbreviations and Q for the quantity ofoutput:ATC = TC/QAFC = TFC/QAVC = TVC/QMC = change in TC/change in QExample : Let’s suppose you are making 50 bottles of wineeach week. You know that your fixed costs add up to $300, andyour variable costs amount to $900. You also know that if youwere to make an extra 5 bottles, your total cost would rise by$60. What is your total cost; average total cost; average total cost;average variable cost; average fixed cost; and marginal cost?Answer: Total cost = $300 + $900 = $1200ATC = $1200/50 = $24AVC = $900/50 = $18AFC = $300/50 = $6
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MC = $60/5 = $12A table with cost data might show the following:
• Ore Mining Example: Cost Data
Q L VC FC TC AFC AVC ATC MC 0 0 0 150 150 150 0 150 6 1 50 150 200 25.00 8.33 33.33 8.33
16 2 100 150 250 9.38 6.25 15.63 5.00 29 3 150 150 300 5.17 5.17 10.34 3.85 44 4 200 150 350 3.41 4.55 7.95 3.33 55 5 250 150 400 2.73 4.55 7.27 4.55 60 6 300 150 450 2.50 5.00 7.50 10.00 62 7 350 150 500 2.42 5.65 8.06 25.00 62 8 400 150 550 2.42 6.45 8.87 ERR 61 9 450 150 600 2.46 7.38 9.84 -
50.00 59 10 500 150 650 2.54 8.47 11.02 -
25.00
a. rent of the ore-mining equipment = $0.20 per horsepower(750 x 0.20 = $150)
b. cost of each worker employed is $50 per period.1. TC = FC + VC 2. AFC = eq FCQ
3. AVC = VCQ 4. ATC = eq TCQ or AFC + AVC
5. MC = eq TVCQ , note the following
TVC = a + bQ, where
b = eq TVCQ = MC6. Cost Elasticity e = eq %TC%Q = eq TCQ . eq QTC
e < 1 increasing returns to scaleε = 1 constantε > 1 decreasing
6. Cubic Form (with Quadratic MC)Cubic — Assumes that both marginal cost and average variablecost functions have U-shapes.
For Referenceonly
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Fig. 2The curves above show typical shapes of a firm’s total cost, totalvariable cost and total fixed cost curves. Total fixed cost isconstant at $50 for all levels of production. Total cost and totalvariable cost increase with higher levels of output. Note thattotal fixed cost and total variable cost always add to total cost.The data used in these graphs (figures 5.5a and 5.5b) is takenfrom the table in
Relationship of TFC, TVC, and TCTFC is constant and unaffected by output level
TVC is always increasing; increasing at a decreasing rate first andthen at an increasing rate
TC has same shape as TVC; but higher by the vertical distanceequal to TFC
Note: These characteristics based on “typical” productionfunction; shapes of cost curves depends on characteristics
of the underlying production function
Average & Marginal cost curves
AFC – always declining but at a decreasing rate
ATC and AVC – U-shaped; declining at first, reaching aminimum, and then increasing at higher output levels
Vertical diff. bet. ATC and AVC is the AFC (changes withoutput level)
ATC and AVC have minimum points at different output levels
MC – generally increasing; with a “typical” production function,MC decreases over a short range before starting to
increase
MC hits AVC and ATC at its minimum points
as long as marginal is below average, average is decreasing (andvice-versa)
8. Short-Run Cost FunctionsIn addition to measuring the costs of producing a givenquantity of output, economists are also concerned withdetermining the behavior of costs as output is varied over arange of possible values.
The behavior of costs is expressed in terms of a cost function.
9. Total Cost FunctionTotal Cost = sum of all costs; FC + TVC
10. Long-Run Cost FunctionsThe long-run cost function is obtained directly from theproduction function by finding the expansion path. Remem-ber, the expansion path for a production process consists of thecombinations of inputs X and Y for each level of Q that satisfythe optimality criterion:
MPC
x
x =
MPC
y
yOver the long-run planning horizon, the firm can choose thecombination of inputs that minimizes the cost of producing adesired level of output. Using the existing productionmethods and technology, the firm can choose:
• the plant size,
• types and sizes of equipment,• labor skills, and
• raw materials
that, when combined, yield the lowest cost of producing thedesired amount of output.
The long-run average cost function (LAC) consists of the lowerboundary (envelope) of all the short-run cost curves.
The relationship between LTC, LMC, and LAC is as follows —The long-run cost function is obtained directly from theproduction function by first finding the expansion path for thegiven production process.
The expansion path for a production process consists of thecombinations of inputs X and Y for each level of output Qthat satisfy the optimality criterion developed earlier.
Recall we derived the condition that the MRTS between twoinputs must be equal to the ratio of the unit costs of the twoinputs for a given input combination to be an optimal solutionto either the output-maximization or cost-minimizationproblem.
MRTS = CxCy
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Graphically, the optimal input combination occurred at the pointwhere the production isoquant was tangent to the isocost line.
NOTE:
LAC = LTC
Q and LMC = ∆LTC∆Q
11. The Long Run Average Cost CurveThe long-run average cost curve is derived from a number ofshort-run average cost curves. For each fixed plant size (shortrun), you look at the lowest costs for that size plant. Thesebottom portions of the different short run cost curves makeup the long run average cost curve.
Fig. 5.6
A firm’s long run average cost curve is the “envelope” of manyshort run average cost curves. All inputs are variable and thefirm has the choice of building or changing to a variety of plantor facility sizes. A small operation (SRAC1) which wants toproduce 300
units will have average costs of $26. A larger one, whichproduces 700 units, can produce each product for $17 (econo-mies of scale). When the firm gets too large (SRAC6), averagecosts rise to $20 (diseconomies of scale).
12. Increasing, Decreasing, and ConstantReturns to ScaleNote that increasing returns to scale is closely associated with theconcept economies of scale (the downward sloping part of thelong run average total cost curve.) Decreasing returns to scalerelates to diseconomies of scale (the upward part of the curve).
Increasing returns to scale occurs when a firm increases itsinputs, and a more than proportionate increase in productionresults. For example, one year a firm employs 200 workers and50 machines and produces 1000 products. A year later itincreases the number of workers to 40 0and the machines to100 (inputs doubled) and the output rises to a level of 2500(more than doubled).
Increasing returns to scale is often accompanied by decreasinglong run average costs (economies of scale). A firm which getsbigger may experience this because of increased specialization,more efficient use of large pieces of machinery (for example, useof assembly lines), volume discounts, etc.
Decreasing returns to scale happens when the firm’s outputrises by less than the percentage increases in inputs. In the lastexample, had the firm’s output risen to 1500, we wouldexperience decreasing returns to scale.
Decreasing returns to scale can be associated with rising long runaverage costs (diseconomies of scale). An organization maybecome too big, thus creating too many layers of management,too many departments, and too much red tape. This lead to alack of communications, inefficiency, and delays in decisionmaking.
Constant returns to scale occurs when the firm’s output risesproportionate to the increase in inputs. What would outputhave to be for this to take place?
13. Marginal UtilityMarginal utility is the additional satisfaction one gets fromconsuming one more item of a good or service. Satisfaction ismeasured in utils (use your imagination). Let’s say that you areabout to eat a pizza consisting of 6 slices. The first piece mightgive you 140 utils of satisfaction (you were starving!). Thesecond slice, your hunger somewhat satisfied after the first,yields you only 60 utils. The third’s down to 20 utils and apossible fourth, if forced upon you, could produce negativeadditional utils (your total would drop.)
14. The Law of Diminishing Marginal UtilityReferring back to the example in the previous objective, you cansee that the marginal utility declines as the person consumesmore slices. This is typical of almost all (beer and othersubstances known to be harmful to body and soul may be soleexceptions…) consumption: the more you have of somethingthe less the additional unit is worth to you.
This phenomenon explains why if you are shopping in asupermarket you only buy a limited quantity of goods. As themarginal utility of, for example, the fifth orange declines, youmay decide that this orange is not worth your additionalexpense.
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Profit-maximizing rules (Short-run):
If price or MR > min. ATC (or TR>TC), produce output whereMR =MC
If min AVC < price or MR < min. ATC (or TVC < TR < TC),produce where MR = MC;
But will incur a loss between zero and TFC (loss minimized)
If price or MR < min ATC, do not produce and loss will equalTFC
Profit-maximizing rules (Long-run):
If price or MR > ATC, produce where MR=MC
If price or MR < ATC, stop production and sell fixed assets
16. Isoquants and the Producer’sequilibriumWhen producing a good or service, how do suppliers determinethe quantity of factors to hire? Below, we work through anexample where a representative producer answers this question.
Let’s begin by making some assumptions. First, we shallassume that our producer chooses varying amounts of twofactors, capital (K) and labor (L). Each factor was a price thatdoes not vary with output. That is, the price of each unit oflabor (w) and the price of each unit of capital (r) are assumedconstant. We’ll further assume that w = $10 and r = $50. Wecan use this information to determine the producer’s total cost.We call the total cost equation an isocost line (it’s similar to abudget constraint).
The producer’s isocost line is:
10L + 50K = TC (1)
The producer’s production function is assumed to take thefollowing form:
q = (KL)0.5 (2)
Our producer’s first step is to decide how much output toproduce. Suppose that quantity is 1000 units of output. Inorder to produce those 1000 units of output, our producermust get a combination of L and K that makes (2) equal to1000. Implicitly, this means that we must find a particularisoquant.
Set (2) equal to 1000 units of output, and solve for K. Doingso, we get the following equation for a specific isoquant (one ofmany possible isoquants):
K = 1,000,000/L (2a)
For any given value of L, (2a) gives us a corresponding value forK. Graphing these values, with K on the vertical axis and L onthe horizontal axis, we obtain the blue line on the graph below.Each point on this curve is represented as a combination of Kand L that yields an output level of 1000 units. Therefore, as wemove along this isoquant output is constant (much like the factthat utility is constant as we move along an indifference curve).
How much K and L should the producer hire? The answer isthat our choice must exist somewhere on this isoquant. If eachpossible choice must lie on this isoquant, then our basis forchoosing one “best” combination should be to choose the leastcost combination. Let’s experiment with some differentpossibilities, by plugging values for L and K into the isocostequation above. Each combination should yield output of 1000units. Several combinations, and their specific total cost aregiven as follows:
L K TC
1,000 1,000 60,000
5,000 200 60,000
10,000 100 105,000
100 10,000 501,000
Now, the firm’s goal is to produce 1000 units at the lowestpossible TC. The lowest total cost on the table is $60,000, so wecan start there. There are two choices which yield this total cost.They are represented below as B1 and B2.
Is there a lower cost combination of L and K available? Yes, wecan produce at a total cost of $52,500 by employing either 250units of K and 4000 units of L, or 800 units of K and 1250units of L. This appears on the graph below.
The second isocost, where TC = $52,500, rests below theformer isocost, where TC = $60,000. If we continue to find
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lower and lower levels of total cost that provide us with 1000units of output, then we will clearly reach lower and lowerpoints on the isoquant. Eventually, we can find a level of totalcost that involves a tangency between the isocost and isoquant.This is pictured below at point A.
In addition to being the lowest cost combination of L and Kthat produces 1000 units of output, pt. A involves a tangencypoint between the isoquant and isocost. That is, the slopes ofthese curves at pt. A are equal. The slope of the isocost is w/r,or –1/5. The slope of the isoquant is the ratio of the marginalproducts, MPL/MPK, which is given as the marginal rate oftechnical substitution (MRTS). Using calculus, it is possible toderive the MRTS as –K/L. Point A satisfies the condition thatK/L = 1/5.
We can solve for K* and L* at pt. A, using (1), (2a) and the factthat, at pt. A, K/L = 1/5. First, substitute (2a) into (1) and theequation K/L = 1/5. We’re left with:
10L + 50(1,000,000/L) = TCand
(1,000,000/L)/L = 1/5
Solve the second equation for L, substitute that result into thefirst equation to get the lowest value for TC (TC*).
TC* = $44,721.36
Once you have TC*, you can substitute this value into theisocost equation above (10L + 50,000,000/L = TC) and thensolve for L* (rounded to the nearest whole number).
L* = 2,236
Going back to (1), we can substitute in L* and TC*, to get K*.
K* = 447
18. Economies of ScaleDeclining long-run average costs over the lower part of thepossible outputs are usually attributed to economies of scale.Economies of scale occur over the range of the long-run costfunction which corresponds to increasing returns to scale of theproduction function. Where do economies of scale comefrom?
1. Plant Economies• specialization in the use of labor and capital
• indivisible nature of many types of capital equipment
• purchase price of different sizes of equipment
2. Firm Economies• materials procurement / quantity discounts
• economies in raising funds (capital procurement)• sales promotion
• technological innovation
• management
19. Glossary of termsCost : The sacrifice incurred whenever an exchange or transfor-mation of resources takes place.
Sunk Cost : A cost incurred regardless of the alternative actionchosen in a decision-making problem.
Cost Function : A mathematical model, schedule, or graph thatshows the cost (such as total, average, or marginal cost) ofproducing various quantities of output.
Opportunity Cost : The value of a resource in its next bestalternative use. Opportunity cost represents the return orcompensation hat must be foregone as the result of thedecision to employ the resource in a given economic activity.
Marginal Cost : The incremental increase in total cost thatresults from a one-unit increase in output.
Cost Elasticity: A measure that indicates the percentage changein total costs associated with a 1-percent change in output.
Economies of Scale : Declining long-run average costs as thelevel of output for the firm (or production plant) is increased.The decline in costs is generally attributed to production ormarketing advantages.
Diseconomies of Scale : Rising long-run average costs as thelevel of output is increased.
Minimum Efficient Scale : The output level at which long-runaverage costs are first minimized.
Capacity: The output level at which short-run average costsare minimized.
Operating Leverage: the use of assets having fixed costs (e.g.depreciation) in an effort to increase expected returns.
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LESSON 17:ECONOMIES OF SCALE
Economies of scale can be of two kinds: internal economiesand external economies. Internal economies of scale are thosewhich arise from the firm increasing its plant size. On the otherhand, external economies arise outside the firm-from improve-ment (or, deterioration) in the environment in which the firmoperates. The economies external to the firm may be realisedfrom actions of other firms in the same or in another industry.While the internal economies of scale relate only to the long-runand determine the shape of the long-run cost curve, the externaleconomies affect the position of the long-run cost curves.
17.1 Internal EconomiesInternal economies are given in a summary form in Fig. 17.1,where these are categorised into real and pecuniary economies.Real economies arise when the quantity of inputs used for a givenlevel of output decreases. While pecuniary economics are thosesavings in expenses which accrue to the firm in the nature ofrelatively lower prices paid for inputs and lower costs ofdistribution. These savings arise due to bulk buying and sellingby the growing firm.
17.1.1 Real Economies of ScaleReal economies are of 4 kinds:
a. Production economies
b. Marketing economiesc. Managerial economies, and
d. Transport and storage economies.
a. Production economies. Production economies arisefrom (a) labour, (b) fixed capital, and (c) inventoryrequirements of the firm. These are:
I. Labour economies. Labour economies arise because of thefollowing factors :
i. Division of Labour Economies . Larger output allowsdivision of labour which reduces cost by increasingspecialisation, by saving time (otherwise lost in passingfrom one operation to another), and providing goodconditions for inventions of a great number ofmachines.
ii. Cumulative volume economies . The technicalpersonnel engaged in production tend to acquiresignificant experience from large-scale production. This‘cumulative volume’ experience helps in higherproductivity and, therefore, reduced costs
II. Technical economies. These are associated with fixedcapital, which includes machinery and equipment. Sucheconomies arise because of the following:
i. Specialised equipment . The production methodsbecome more mechanized as the output scale increases.This would imply more specialised capital equipment andlower variable costs.
ii. Indivisibility. The machinery and equipment generallyhave the property of indivisibility, which means thatequipment is available only in minimum sizes or indefinite ranges of size. When output is increased fromzero to the maximum capacity level of the machine, thesame machine and equipment are used. As a result thecost of machine is shared between more and more unitsof output. In short, as the output is increased, themachinery and equipment comes to be utilised moreintensively and consequently the cost of production perunit declines.
iii. Integration of processes . The large size firms enjoyeconomies of large machines. Integration of processesoccurs where one large automatic transfer ornumericallycontrolled machine can carry out a series of consecutiveprocesses, saving labour cost and time required to set upthe work on each of a series of successive specialisedmachines.
iv. Economies of increased dimensions , for many types ofequipment both initial and running costs increase lessrapidly than capacity (e.g., tanks, blast furnaces and otherstatic and mobile containers). These result in economiesof increased dimensions. Any container whose externaldimensions are doubled has its volume increased eighttimes, but the area of its surface walls would haveincreased only four times. This reduces material costsand, where appropriate, heat loss and surface, air andwater resistance per unit.
v. Economies in set-up costs . The larger the scale ofoutput,the more a multipurpose machinery is left to one set-upand, therefore, set-up costs of general purpose machinesreduce.
vi. Economies of overhead costs . Obviously, the larger thescale of output, the lower the unit costs of initial fixedexpenses which are need for a new business or a newproduct.
III. Inventory economies. Role of inventories is to meet therandom changes in the input and output sides oftheoperations of the firm. It has been found that the input aswell as output inventories increase at a rate lower than thatof increase in output. These economies arise due to thephenomenon of massed resources.
b. Marketing Economies. These economies arisebecause
I. The advertising expenditure is generally found to haveincreased less than proportionately with scale. Consequently,larger the output, smaller the advertising cost per unit.Similar situation prevails in case of other types of sellingactivities.
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II. The development and adoption of new models and designsinvolve considerable expenses in R&D. The larger theoutput, more thinly this R&D expenditure spreads overoutput.
c. Managerial Economies. Managerial economies arisebecause:
I. Larger the firm, greater are the opportunities for the divisionof managerial tasks. The division of managerial tasks helpsmanagers to specialise in their own areas of responsibility,thus leading to greater efficiency.
II. Teamwork experience. By working in a team, themanagers of large firms tend to acquire a morecomprehensive outlook as well as a quicker and betterdecision-making ability.
III. In a large firm, with decentralization in decision-making,the delays in the flow of information is reduced, therebyincreasing the efficiency of management.
IV. Modern managerial and organisational techniques.Large firms provide opportunities for the introduction ofmodern managerial techniques and organisationalrestructuring. These help the management to increaseefficiency.
d. Transport and Storage Economies. Storage costs obviouslyfall with the increase in the size of output, as it provides theeconomies of increased dimensions (discussed already). Thetransportation costs, on the other hand, involve an L-shapedaverage cost curve-transport unit costs falling up to the pointof the full capacity and remaining constant thereafter.
17.1.2 Pecuniary Economies of ScaleThese economies include the discounts that a firm can obtaindue to its large size. These discounts may be in the nature of:
i. Lower raw material price due to bulk buying.
ii. Lower cost of capital, as banks usually place greater faith inthe large firms and, therefore, charge lower rate of interest.
iii. Offers of lower rate’s for advertising to large firms becauseof their large-scale advertising.
iv. Lower transportation rates due to bulk transportation.
v. In case the large firm is able to attain a size to gainmonopsonistic power or is able to create an image ofprestige to be associated with the firm it may be in a positionto save on labour costs by paying lower wages and salaries.
17.2 External EconomiesLike internal economies, external economies also help in cuttingdown production costs. With the expansion of an industry,certain specialised firms also come up for working up the by-products and waste materials. Similarly, with the expansion ofthe industry, certain specialised units may come up for supply-ing raw material, tools, etc., to the firms in the industry.Moreover, they can combine together to undertake research, etc.,whose benefit will accrue to all the firms in the industry. Thus, afirm benefits from expansion of the industry as a whole. Thesebenefits are external to the firm, in the sense that these arise notbecause of any effort on the part of the firm but accrue to it dueto expansion of industry as a whole. In this sense these
economies are external to the firm. All these external economieshelp in reducing production costs.
17.3 Diseconomies of ScaleWhen a firm continues to expand its size, a stage comes whendiminishing returns to scale set in. As a firm expands beyond alevel, it encounters growing diseconomies. These diseconomiesmore than cancel out the economies of large-scale productionand cause average costs of production to start rising. Let usdiscuss in detail reasons for such a phenomenon.
Technical factors are unlikely to produce diseconomies of scale.If inefficiencies arise as a result of over large plant size then theycan be avoided by replicating units of plant of a smaller size. Infact, technical factors are more likely to ‘limit’ the sources of scaleeconomies than to act as a source of diseconomies.
When diseconomies of scale arise they are more likely to beassociated with the human and behavioral problems of managing alarge enterprise. Let us understand this with the he1p of ahighly simplified organisation chart or a managerial hierarchygiven in figure below. Both Vijay and Ashok (who may, forexample, be the divisional managers) are responsible to Ram. IfVijay wants to communicate with Ashok he must follow theformal chain of command and pass his message through Ram,whose function is coordination. This will be a time-consumingprocess involving red-tapism but, given a large organisationwith a large number of managers, such indirect coordinationmay be the only practical method of communicating whileavoiding disorganization and chaos.
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Vijay Ashok
Now, if the firm grows further, then another layer of manage-ment must be inserted between Ram, Vijay and Ashok. Thisincreases the chain of command and Vijay, in order to commu-nicate with Ram, must pass his message through anintermediary. This increases the costs of communication andalso introduces the problems of possible message distortion andmisinterpretation with corresponding implications fororganisational efficiency. These arguments can be well-explainedwith the help of Williamson’s concept of ‘control loss ‘. Thedecisions taken by a top executive must be based on informa-tion passed across a series of hierarchical levels. In turn, theinstructions based on this information must be transmitteddown through these successive stages. This transmission resultsin a serial reproduction loss or distortion, of both the informationand instructions. This may occur even when the individualsforming the hierarchy have identical objectives. Increases in thescale of the hierarchy result in reduction of the quality of theinformation reaching the top coordinator and of the instruc-tions passed down by him to lower-level personnel. Moreover,since the capacity of the top administrator for assimilatinginformation and issuing instruction is limited he can, after apoint, only cope with an expansion of the hierarchy by sacrific-ing some of the details provided before the expansion. Thus,the quantity of information received and transmitted per unit of outputwill be less after expansion than before it. This is known as ‘controlloss’. As a result it can be argued that operating units will notadhere as closely to the top administrator’s objectives of costminimisation as they did before the expansion.
Secondly, there is the problem of morale and motivation ofboth management and labour force. It is often argued that dueto lack of personal touch the spirit in a large firm is less thanthat in a small firm. The labour force is more closely identifiedwith small firm and this results in improved productivity andgreater overall loyalty to the organisation. Moreover, sincemanagement of a large firm may feel more secure they maybecome sluggish and develop lack of enterprise. This sluggish-ness is- absent in managers of small firms who see the generallypresent threat of being put out of business
In short, we may say that decreasing returns to scale will becomeoperative when management becomes a problem. This problemis more serious in agriculture than in industry: as their opera-tions expand the law of decreasing returns becomes operativeearlier in agriculture than in industry
Economies/Diseconomies of Scale
AC 0 ES CRS DES Q
ES: range of output encompassing economies of scale(decreasing unit costs; [includes increasing returns to scale])
CRS: range of output encompassing constant returns to scale(constant unit costs)
DES: range of output encompassing diseconomies ofscale(increasing unit costs; [includes decreasing returns to scale])
17.4 The Concept Of Learning CurveThe learning curve analysis is based on the assumption thatworkers improve with practice, so the per unit cost of addi-tional output declines. The reduction in cost due to thislearning process is known as the learning curve effect, wherelearning curve graphically depicts the relationship- betweenlabour cost and additional units of output.
Learning curve is measured in terms of percentage fall inmarginal labour cost when output doubles. Table 17.6 presentsdata for a “80 per cent” learning curve. Each time outputdoubles, the cost of producing this additional output decreasesto 80 per cent of the previous level. This implies 10 per centreduction in addition to cost.
The pattern of reduction in factor cost is based on the follow-ing formula:
Lx=k.X”
where
x = production unit
Lx= units of labour hours for producing xth unit.
k = cost to produce first unit.
n = log slope/log 2, where slope equals the rate atwhich cost of producing additional unit declines,
In a similar way we can find cumulative labour hours.
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Table 17.1 : Measurement of Learning Curve
Output unit Labo
ur hours
Cumulative Cumulative Cost of Cumulativ
e
labour hours average labour hours average
labour
labour hours = col. 2 x Rs. 10 cost
= col. 3 -+- col. 1 = co/. 4 x
Rs. 10 (1) (2) (3) (4) (5) (6)
1
2,000
2,000 2,000.0 20,
000
20,000
2
1,600
3,600 1,800.0 16,
000
18,000
4
1,280
6,284 1,558.5 12,
800
15,585
8
1,024
10,692 1,336.5 10,
240
13,365
16 820
17,840 1,115.0 8,2
00
11,150
32 650
29,357 917.4 6,5
00
9,174
64 530
47,849 747.6 5,3
00
7,476
With the help of cols. 1 and 5 in Table 17.1, we can plot thelearning curve (Fig. 17.2).
The learning curve is expressed in terms of marginal labourcost. The average cost as expressed by cumulative average labourcost is also seen declining (col. 6, Table 17.6), showing theimpact of improving efficiency of labour with practice.
25
unit 20
labour 15
cost 10
(Rs. 000) 5
0
8 16 32
17.5 Economies of ScopeWhile discussing the law of variable proportions and econo-mies of scale, it was implicitly assumed that the firm producesonly one product. In modem-day business we frequentlyencounter firms (like Hindustan Lever, P&G, Nestle, etc.) whichproduce more than one products. It has been observed that amulti-product firm often experiences economies or diseconomies ofscope. If a single firm producing multiple products can togetherproduce them cheaper compared to a situation where eachproduct is produced by a separate firm, we say that the econo-mies of scope exist in such a case. For example, if firm Aproduces 100 units of X and 500 units of Y per month at thetotal cost of Rs.1,00,000. While, on the other hand, suppose Xand Y were produced by two separate firms: the cost ofproducing 100X by firm B being Rs.25,000 and the cost ofproducing 500r by firm C being Rs.90,000. Firm A thenexperiences economies of scope because its cost of producingboth goods X and r together is Rs.1 ,00,000, which is less thanthe cost of producing them separately (Rs.25,OOO + Rs.90,000= Rs. l, 15,000). This difference in the cost of producing goodsjointly by a firm and producing them separately by separatefirms can be used to measure the degree of economies of scope.
Degree of economies of scope =
TC(Q,) + TC(Q2) - Tc(QI + Q2)
Tc(QI + Q2)
where, TC (QI) = total cost of producing QI units of good 1only;
TC (Q2) = total cost of producing Q2 units of good 2 only;
TC (QI +Q2) = total cost of producing goods I and 2 jointly;producing QI units of goods 1 and Q2 units of goods 2.
Thus, in the case of Firm A in example above, the degree ofeconomies of scope equals
Rs. 25, 000 + Rs. 90, 000 - Rs.l, 00, 000 - 0.15
Rs.l, 00, 000
If the degree of economies of scope is positive it implies thateconomies of scope exist. When this measure becomesnegative, it means that producing goods separately is cheaperthan producing them together.
The main reasons for the existence of economies of scope are:
i. In case a firm produces several products, it is very likely thatmany of them use common production facilities andinputs. For example, a firm producing electrical goods maymake use of the same testing or assembly line facilities forgeysers, food-warmers, fans, irons, etc.
ii. It happens many a time that the production of one goodresults in by-products that can be sold by the producer,thereby gaining a cost advantage in the production of themain product. For example, a sugar mill gets molasses as aby-product, which it can sell directly in the market or can usein the production of liquor in its own distillery.
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BUSINESS ECONOMICS-I17.6 SummaryEconomies of ScaleAre the factors that cause average cost to be lower in large-scaleoperations than in small scale ones
• Specialisation with a larger workforce it is possible to divideup the work and recruit and train individuals who exactlymatch the requirements. They can then become specialists.
• Technical firms benefit from being able to use machinery.Some items are only worthwhile being purchased and usedwhen the fixed costs can be spread over a larger output.
• Purchasing As firms grow they can benefit from being ableto buy in bulk.
Diseconomies Of ScaleAre the factors that cause costs per unit to increase as the scaleof output increases.
• Communication: In larger organisations people have to behired to pass on communication, extra bits of paper are usedand the message has more opportunity to get distorted as itpasses through more layers.
• Co-ordination: Problems occur as it is much more difficultto coordinate so many people. Empowerment might causeproblems. The extra cost of meetings.
• Motivation: Being part of a larger organisation might causea lack of motivation amongst some employees.
Are Bigger Firms Therefore Better?The answer to that question is obviously ‘it depends’, as always!Clearly it depends on the opposing effects of the diseconomiesand economies of scale. If the diseconomies outweigh theeconomies then the answer is ‘no’. Vice-versa. In some cases thesmall firm has advantages over the larger firm, especially interms of service, closeness to the market and their ability toexploit niches that will just not be profitable for larger firms topursue.
Notes
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TUTORIAL 4
1. Multiple Choice Questions1. An upward-sloping short-run marginal cost curve shows
that:
• with a fixed amount of capital, as more and more labor isadded, output increases at a decreasing rate, and thus eachunit is more expensive than the previous unit.
• with a fixed amount of labor, as more and more capital isadded, output increases at a decreasing rate, and thus eachunit is more expensive than the previous unit.
• with a fixed amount of capital, as more and more labor isadded, output increases, and thus marginal cost increases.
• with a fixed amount of capital, as more and more labor isadded, output decreases, and thus marginal cost increases.
• with a fixed amount of labor, as more and more capital isadded, output increases at an increasing rate, and thus eachunit is more expensive than the previous unit.
2. Consider a firm that has just built a small plant, which cost$4,000. Each unit of output requires $2.00 worth ofmaterials. Each worker costs $7.00 per hour. Fill in thefollowing table, and use it to answer the next four questions.
Table 1
Number of Worker Hours Output Fixed CostVariable Cost Total Cost Marginal Cost Aver-age Variable Cost Average Total Cost
0 0 — — —
50 400 100 900 150 1300 200 1600 250 1800 300 1900 350 1950 After what level of worker hours does diminishing returns setin?
2• 50
• 100
• 150
• 200
• 2503. Based on Table 1, at what output is average variable cost
minimized?
3
• 400
• 900
• 1300
• 1600
• 1800
4. Based on Table 1, at what output is average total cost (ATC)minimized?
4• 900
• 1600
• 1800
• 1900
• 19505. Refer to Table 1. What is the relationship between marginal
cost (MC), average variable cost (AVC), and average total cost(ATC) when the firm is producing 1300 units of output?
5
• MC is increasing, AVC is increasing, and ATC is increasing.
• MC is increasing, AVC is increasing, and ATC is decreasing.
• MC is increasing, AVC is decreasing, and ATC is decreasing.
• MC is decreasing, AVC is increasing, and ATC is decreasing.• MC is decreasing, AVC is decreasing, and ATC is decreasing.
6. If marginal cost is increasing but less than average total cost,what do we know about average total cost?
6
• Average total cost is increasing.
• Average total cost is constant.
• Average total cost is decreasing.• Any of the above could be true.
• not enough information to tell
7. If the firm has economies of scale in the long run, then thelong-run average cost curve is:
7
• upward-sloping.
• horizontal.• downward-sloping.
• It depends on whether there are diminishing returns.
• It depends on the minimum efficient scale.
8. Which of the following is the best explanation fordiseconomies of scale?
8
• coordination problems• indivisibilities
• gains from specialization
• diminishing returns
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BUSINESS ECONOMICS-I• Both Answers 1 and 4 are correct.
9. Which of the following statements is true?
9
• If marginal cost is decreasing, average variable cost must bedecreasing.
• If marginal cost is decreasing, average total cost must beincreasing.
• If average total cost is decreasing, marginal cost must bedecreasing.
• If marginal cost is greater than average variable cost, averagevariable cost must be increasing.
• All of the above statements are true.
10. Which of the following statements is FALSE?
10• If a firm has diminishing returns in the short run, it will
have diseconomies of scale in the long run.
• If there are production indivibilities, the long-run averagecost curve will be downward-sloping.
• The minimum efficient scale occurs when long-run averagecosts reach their lowest point.
• One reason for diseconomies of scale is increasing inputcosts.
• All of the above are false statements.11. Refer to Figure 1. Diminishing returns set in at point:
Figure 1
11
• a
• b
• c
• d• Can’t tell from the graph given.
12. Refer to Figure 1. At which point are there decreasing returnsto scale?
Figure 1
12
• a• b
• c
• d
• none of the above
2 Production Consultant II: Carefully explain if the followingstatements are true or false: (Hint: you should draw a graphof the appropriate cost curves to help you answer.)a. If average cost is decreasing, marginal cost must be
decreasing.
b. If average cost is increasing, marginal cost must beincreasing.
c. If there are diminishing returns, the short-run averagecost curve must be positively sloped.
d. If there are diminishing returns, the marginal cost curvemust be positively sloped.
Notes
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TUTORIAL 5
1. Case StudyTechnological Change and Government SubsidiesLEAD STORY-DATELINE: Business Week April 16, 2001
We tend to think of the microprocessor king Intel Corporationas an independent private company. Sometimes though, wewonder if anything is purely private or purely public, for thatmatter. After all, private airline companies land their planes atpublic airports. Private trucking companies use super-highwaysfunded by the federal government. Why would it be differentfor Intel? In many ways, it is not-especially when it comes totechnological change.
Since the first Sumerian clay tablets 5,500 years ago, the progressof humans is directly related to the ability to store, process, andretrieve information. In recent decades, that progress has beenamazing. The power of chips has been doubling every 18months, creating desktop super-computers, storehouses ofdigital data, and smarter cars and home appliances. Behind thisprogress in silicon technology are the steady advances inmicrolithography-the process used to “print” ever-smallercircuits on silicon wafers. Further expansion in the InformationAge depends upon on a major leap in lithography becausesmaller is better.
Intel corporation leads a consortium of private companies,national laboratories, and academics in the development ofextreme ultraviolet (EUV) radiation to reduce circuit lines to aminuscule 35 nanometers or even less. The microlithographymachine is like a complex stenciling tool. It projects a circuitpattern through reducing lenses onto a high-sensitive coatingon a silicon wafer. Wherever the light strikes, the coatinghardens. Then the coating’s soft regions can be etched away,leaving a maze of lines that further processing turns intomillions of transistors and connections. Federally fundedcollaborations with the national labs helped solve manytechnical problems, and AT&T got $2 million from theCommerce Department, which it used to boost U.S. opticstechnology.
Then a crisis came. After gaining control of Congress in 1994,Republican lawmakers axed funding for joint research amongnational labs and private companies. Intel put together aconsortium involving Sandia, Livermore, and Lawrence Berkeleynational labs, along with chipmakers AMD, Infineon Technolo-gies, Micron Technologies, Motorola, and equipment suppliers.Intel coughed up the lion’s share of the $250 million budget,but won a guarantee that it would get the new lithographymachines first, before other consortium members. Ironically,such feats may now be made even more difficult as the BushAdministration plans to withhold funding for one of theprograms that jump-stared this project.
Thinking About The Future!Japan has two giant lithography suppliers, Nikon Corporationand Canon Inc. To build a production-ready version of Sandia’sexperimental prototype, Intel in 1998 wanted to license thedesign to Japanese suppliers as well as to the (former) SiliconValley Group Inc. (SVG), the main U.S. lithography company.Then, international trade concerns came to the fore. Washingtonpoliticians and Silicon Valley executives alike raised a fuss abouthanding the crown jewels to the Japanese. So the consortiumbrought in a Dutch company, ASM Lithography (ASML). As itturns out, SVG has now been acquired by ASML (though thedeal had been delayed by national security concerns). There is alot at stake. When these new chips are fabricated, they will maketoday’s Pentiums seem like Model Ts. It could also deal aknockout blow to a rival electron-beam approach beingdeveloped by Nikon and IBM, although IBM has wisely nowjoined the EUV group as well.
Talking It Over and Thinking it Through!1. In economics the subject of this article is the technology of
production. What is a production function and what ishappening to it in this new chip technology?
2. Does this idea of producing more with less conflict with thelaw of diminishing returns?
3. The prototype EUV machine, currently at Sandia NationalLaboratories is the result of 13 years of work and more than$250 million in research-and-development funding. Eachnew lithography machine will cost $40 million. These costsexceed what small corporations could fund. Does this kindof R&D expense have implications for corporate size andindustrial concentration?
4. Are there long-term advantages to government funding ofsuch expensive R&D through the national laboratories?
2. Multiple Choice Questions1. Diseconomies of scale occur when
• a firm’s average total cost increases with increased production.
• only one firm is producing the good that consumers wish topurchase.
• a firm pays a lower price for inputs as its level of productionincreases.
• a firm has a high level of initial sunk costs, such asmanufacturing equipment.
• there are perfectly competitive markets.
2. Which of the following does NOT represent a firm’s explicitcosts?
• costs related to workers salaries• the amount paid by the firm for employee health benefits
• the firm’s total accounting costs
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BUSINESS ECONOMICS-I• the value of the CEO’s time
• the electricity bill
3. The marginal cost curve intersects the short-run average costcurve at a level of output
• greater than the level of output at the minimum point ofthe short-run average cost curve.
• less than the level of output at the minimum point of theshort-run average cost curve.
• equal to the level of output at the minimum point of theshort-run average cost curve.
• greater or less than the level of output at the minimumpoint of the short-run average cost curve.
• where the marginal cost curve is unrelated to the short-runaverage cost curve.
4. In which of the following examples do firms NOT have toworry about “spreading the costs out?”
• an electric company with the high initial cost of installingelectric lines
• a firm that incurs costs from indivisible inputs
• a seasonal fruit picking operation that often has to hire moreworkers during busy periods
• a small low-output potter who must purchase a new kilnbefore pots can be created
• an airline that just purchased a new plane
5. Which of the following is NOT an implicit cost?
• the impact on a firm’s reputation of producing a poorproduct
• the opportunity cost of an entrepreneur’s time
• the value of alternative inputs that could have beenpurchased
• the total amount a firm spends on advertising new products
• the opportunity cost of investment capital
6. Which of the following is NOT a reason why economies ofscale may exist?
• it is cheaper for a firm to make only a small quantity of oneitem and charge a high price.
• firms are more productive due to increased inputspecialization as output increases.
• the cost of indivisable inputs can be spread over more unitsas output is increased.
• companies often face downward sloping long-run averagecost curves.
• large start-up costs make higher output levels desirable.
7. At levels of output where the firm’s short-run average costcurve is increasing,
• the marginal cost curve is above the short-run average costcurve.
• the marginal cost curve is below the short-run average costcurve.
• the marginal cost curve is equal to the short-run average costcurve.
• the marginal cost curve may be above or below the short-runaverage cost curve.
• none of the above are true.
8. Minimum Efficient Scale (MES) represents• the least a firm can charge consumers and still make a profit.
• the greatest number of employees a firm can hire and stilloperate efficiently.
• the price at which all units supplied to the market will bepurchased.
• the output at which the long-run average cost curve becomeshorizontal.
• the output at which the long-run average cost curve becomesvertical.
9. A firm’s variable costs
• directly reflect the price of the company’s outputs.
• are dependent upon the level of fixed costs in the long-run.
• are always equal to the company’s total average costs in thelong-run.
• are determined by quantity of output produced by a firm.• decrease as output increases.
10.A firm’s average fixed costs
• are determined by dividing the total fixed cost by theamount produced.
• are always larger than variable costs in the short- and long-run.
• are the same no matter what quantity the firm produces.• are equal to zero only when the level of production is also
zero.
• always increase as output increases.
11.If the marginal product of labor is increasing,
• output is increasing at an increasing rate.
• output is increasing at a constant rate.• output is increasing at a decreasing rate.
• output is decreasing.
• There is not enough information to answer the question.
12.If the firm is experiencing diminishing returns to labor (inthe short run), total output is ________, and marginal costis __________.
• increasing, increasing• increasing, decreasing
• decreasing, increasing
• decreasing, decreasing
• increasing, constant
3. Long Answer Questions13. 14. 15. 16. 17.
Suppose you are thinking of starting your own mountain bikecompany, “Dirt Lovers.” You calculate that your initial costs foryour plant and equipment will be $10,000. The wage is $15 perhour, and each bike requires $50 of materials. You determinethat producing 5 bikes will require 15 hours of labor, 25 bikes
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BUSINESS ECONOMICS-I
will require 100 hours of labor, and 50 bikes will require 250hours of labor. For each level of production, 5, 25, and 50bikes, calculate the following: Total Fixed Cost, Average FixedCost, Total Variable Cost, Average Variable Cost, Average TotalCost, and Marginal Cost.
2. In the production of a new airplane, workers often “learn bydoing.” With each plane they build, the workers determine amore efficient method for building the next plane. Whatdoes this imply about the long-run average cost curve andthe economies of scale facing the aerospace industry?Explain.
Notes
BUSINESS ECONOMICS-I
111
We have pointed out that the theory of supply and demand is atheory of price in competitive markets. In this chapter, wedraw on the previous two chapters and show how the supplycurve is determined by price competition and profit maximiza-tion.We have now built up enough background to study whateconomists call “industrial organization” — that is, the studyof industries, including their organization and structure, howthey conduct business, how they respond to change andevolve, and how efficiently they perform.Economists believe all these things are interrelated, so this issometimes called a structure/conduct/performance ap-proach.
After you complete this chapter, you should be able to:
• What is a market?
• What are the different type of market structures?• What is competition?
• Conduct and performance of these markets
• Theories of the firm : maximizing & non-maximising
Market Structures
Market Structures
• Type of market structure inf luences how a f i rm behaves:
– Pricing
– Supply
– Barriers to Entry
– Efficiency
– Competit ion
Market Structures
• Degree of compet i t ion in the industry
• High levels of compet i t ion –Perfect Compet i t ion
• L imited Compet i t ion – Monopoly
• Degrees o f compet i t ion in between
Market Structure
• Determinants o f market s t ructure
– Freedom of entry and exit
– Nature of the product – homogenous (identical) differentiated?
– Control over supply/output
– Control over price
– Barriers to entry
UNIT IVTHE MARKET STRUCTURE AND THE
FACTORS MARKETCHAPTER 7:
MARKET STRUCTURE AND COMPETITION
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BUSINESS ECONOMICS-I
Market Structure
• Perfect Compet i t ion:– Free entry and exit to industry
– Homogenous product – identical so no consumer preference
– Large number of buyers and sel lers – no individual seller can influence price
– Sel lers are pr ice takers – have to accept the market pr ice
– Perfect information avai lable to buyers and sel lers
Market Structure
• Examples o f per fect compet i t ion:
– F inanc ia l markets – stock exchange, currency markets ,
bond markets?
– Agriculture?
• To what extent?
Market Structure
• Advantages of Perfect Competit ion:
• High degree of competit ion helps al locate resources to most eff ic ient use
• Price = marginal costs
• Normal prof i t made in the long run
• Firms operate at maximum eff ic iency
• Consumers benefit
Market Structure
• What happens in a competit ive environment?– New idea? – f i rm makes short term
abnormal prof i t– Other f i rms enter the industry to take
advantage of abnormal prof i t– Supply increases – price falls– Long run – normal prof it made– Choice for consumer– Pr ice suff ic ient for normal prof i t to be made
but no more !
Market Structure
• Imperfect or Monopol ist ic Competit ion– Many buyers and sel lers– Products di f ferent iated– Relat ively free entry and exit– Each f i rm may have a t iny ‘ monopo ly’
because of the dif ferentiat ion of their product
– F i rm has some contro l over pr ice– Examples – restaurants, professions –
sol ic itors etc, bui lding f irms – plasterers, p lumbers etc
Market Structure
• Oligopoly – Competit ion amongst the few– Indust ry dominated by smal l number o f la rge f i rms– Many f i rms may make up the indust ry
– High barr iers to entry
– Products cou ld be h igh ly d i f fe rent ia ted – brand ing or homogenous
– Non – pr ice compet i t ion
– Price stabi l i ty within the market - k inked demand cu r ve ?
– Potential for col lusion?
– Abnormal prof i ts
– H igh degree o f in te rdependence between f i rms
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Market Structure
• Examples o f ol igopolist icstructures:– Supermarkets
– Banking industry
– Chemicals
– Oil
– Medicinal drugs
– Broadcasting
Market Structure
• Measur ing Ol igopoly:• Concentration ratio – the proport ion
of market share accounted for by top X
number of f i rms:– E.g. 5 f i rm concentrat ion rat io of 80% -
means top 5 f ive f i rms account for 80% of market share
– 3 f i rm CR of 72% - top 3 f i rms account for 72% of market share
Market Structure
• Duopoly:• Indust ry dominated by two large
f i rms
• Poss ib i l i ty of pr ice leader emerging – r ival wi l l fo l low pr ice leaders pr ic ing decis ions
• High barr iers to entry
• Abnormal prof its l ikely
Market Structure
• Monopo ly :
• Pure monopo ly – industry is the f i rm!
• Actual monopoly – where f i rm has >25% marke t share
• Natura l Monopo ly – high f ixed costs – gas, e lectr ic i ty, water, te lecommunicat ions, ra i l
Market Structure
• Monopoly:– High barriers to entry
– Firm controls price OR output/supply
– Abnormal profits in long run
– Possibil ity of price discrimination
– Consumer choice l imited
– Prices in excess of MC
Market Structure
• Advantages and disadvantages of monopoly:
• Advantages:– May be appropr iate i f natural monopoly– Encourages R&D– Encourages Innovation– Development of some products not l ike ly
without some guarantee of monopoly in product ion.
– Economies of Scale can be gained –consumer may benef i t
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Market Structure
• Disadvantages:
– Exploitation of consumer – higher prices,
– Potential for supply to be l imited- less choice
– Potential for inefficiency –
X -ineff ic iency – complacency
over controls on costs
Market StructureKinked Demand Curve:
Price
Quantity
D = elastic
D = Inelastic
£5
100
Kinked D Curve
Notes
115
BU
SIN
ES
S E
CO
NO
MIC
S-I
As usual, the first step will be some terminology. Economistsin general recognize four major types of market structures(plus a larger number of subtypes):• Perfect Competition• Monopoly• Oligopoly• Monopolistic competitionFor now, I will just define the first of the four, and then useconcepts related to “Perfect Competition” to define the otherthree.
18.1 What is a Market?These are forms of markets. We might pause for a moment tothink about just what a market is. A market consists of all the(potential) buyers and sellers of a particular good orservice.In order for a market to exist, though, these potential buyersand sellers must have some way to communicate offers to buyand sell with one another. One possibility is for them to cometogether and yell at one another (as at the New York StockExchange). In traditional societies, craftsmen in a particular trademay all be located on the same street, so that customers knowwhere to go to buy.Of course, many modern markets make use of a wide range ofelectronic communication methods, as do NASDAQ and theinternational currency markets.Thus, it is natural to identify a market with the place wheretraders come together (as in the case of a stock market) or themeans by which they communicate. But the market consists ofthe people willing to buy and sell.
18.2 Perfect CompetitionWhat many economists call “P Competition” is an idealizedstructure of an industry in which price competition is dominant— in fact the only form of competition possible. The terminol-ogy “Perfect Competition” is quite common but not quiteuniversal. The term “Pure Competition” is also sometimesused. I will use the term “P-Competition,” where the P canstand for perfect, pure, or price competition — whichever youlike.A P-Competitive structure is defined by four characteristics. Foran industry to have a P-competitive structure, it must have allfour of these characteristics:• Many buyers and sellers• A homogenous product• Sufficient knowledge• Free entryThese are all characteristics that favor price competition. Each ofthese characteristics will be explained in turn.
18.2.1 Many Buyers and SellersThe idea is that the sellers and buyers are small relative to thesize of the market, so that no one of them can “fix the price.”If there are “many small sellers,” it makes it much harder forany seller or any group of sellers to “rig the price.” Similarly, ifthere are “many small buyers,” there is little opportunity forbuyers to “rig the price” in their own favor.Each seller reasons as follows: “If I try to charge a price abovethe market price, my customers will know that they can get abetter price from my competitors. My own share of the marketis so small that all of my customers will be able to buy whatthey want from the competition — and I won’t have anycustomers left!” Thus, the seller treats the price as being givenand determined by “the forces of the market” independently ofher own output.How many sellers? How small? There is no absolute answer tothat question; but there must be enough sellers and they musteach be small enough so that each regards the price as beingdetermined by the market, so that none of the sellers sees anyopportunity to push the price up by cutting back on his or heroutput.Similarly, there must be enough buyers, and each small enough,that each one treats the price as being determined by the market,and beyond her or his own ability to influence.These conditions encourage the buyers and sellers in the marketnot even to try to control the price, but instead to competeagainst one another whenever quantity supplied differs fromquantity demanded, driving the price toward the equilibrium ofsupply and demand.
18.2.2 HomogeneityIf the product (or service) of one seller differed significantlyfrom that of another seller, then each seller would probably beable to retain at least some of the customers, even at a very highprice. These would be the customers who just prefer this seller’sproduct (or service) to that of someone else. The assumptionof homogenous products serves to rule that out.But this assumption should not be taken too literally. No twopotatoes are exactly alike. We are not assuming that the goodsare alike: only that the goods produced by one supplier are goodsubstitutes for those offered by another seller. Thus, thepotatoes don’t need to be just alike — provided that, on theaverage, Farmer Jones’ potatoes are just as good as FarmerGreen’s.This is especially important with respect to services. It would behard to prove that two haircuts are just alike! But so long as thehaircuts supplied by one barber are substitutable for the haircutssupplied by another — and their conversation is about equallyamusing — then the “homogenous products” assumption isfulfilled.
LESSON 18:PERFECT COMPETITION
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“Homogenous products” means all suppliers sell products thatare perfect substitutes. If different sellers sold differentproducts, then customers might be reluctant to switch supplierswhen one supplier raises the price. They might stick with thesupplier even at the higher price, because, even at the higherprice, they like the product of that firm better than the productof another firm. By ruling this out, the homogeneity ofproducts encourages price competition.
18.2.3 KnowledgeSome versions of the “perfectly competitive” structure include“perfect knowledge” as one of its characteristics — but, ofcourse, “perfect knowledge” never exists in reality.Perfect information is a little less clear than the other assump-tions — we can hardly assume that people know everythingthere is to know! In practice, what is important is that eachbuyer and seller knows all about her or his opportunities tomake deals, that is, knows the terms on which other marketparticipants will buy and sell. Remember what we said in theparagraph on “many small sellers:” a seller would assume thather or his customers would know if the competition wereselling more cheaply. If the customers didn’t know that theyhad alternatives, then even a very small seller might get awaywith pushing the price up, without losing many customers.Thus, the “perfect information” assumption complements theother assumptions. The assumptions that there are many smallbuyers and many small sellers, and the assumption of freeentry, all mean that buyers and sellers have many alternatives ofpotential buyers and sellers to choose among. The assumptionof sufficient information says that they know what thosealternatives are.Traders need to know quite a bit to compete effectively inmarkets. They need to know the terms on which other peopleare offering goods and services, or offering to buy; the qualityof the goods and services offered, and enough about costs tojudge whether the trade is profitable or not. This is what Imean by “sufficient knowledge”
18.2.4 Free EntryRemember Adam Smith’s concept of the “natural price:” whenthe price of beer is high, so that brewing is especially profitable,people will enter the brewing trade and their competition withthe established breweries will force the price down toward the“natural” price. As Smith was aware, in the long run the entryof new competition — or the exist of unprofitable firms fromthe industry, to go into other trades — is one of the mostimportant aspects of competition and is thus one of the fourcharacteristics of the P-competitive structure.Free entry means that new companies can set up in business tocompete with established companies whenever the newcompetitors feel that the profits are high enough to justify theinvestment. This is, first and foremost, a legal condition. Thatis, in a “perfectly competitive” market there are no governmentrestrictions on the entry of new competition. This legal status isoften called by the French phrase “laissez faire,” meaning “letthem make (whatever they want to make for sale).” But it couldalso be a practical condition. For example, if no-one could setup in business without enormous capital investments, that
might prove an effective limit on the entry of new competition— especially if, for some reason, the capital cannot be raised byborrowing or issuing shares.Now you can very well sum up the four characteristics of P-Competition :
1. Many Small Sellers
The more sellers there are, the more substitutes the consumerhas
2. Homogenous Product
When the product is homogenous, then the substitutes are“perfect substitutes.”
3. Sufficient Knowledge
When customers know the prices offered by other sellers, theywill be better able to switch — increasing elasticity further.
4. Free Entry
In the long run, companies may even enter the market toprovide still more substitutes
18.3 Other Market FormsThe other three market structure models can be defined interms of the ways in which they deviate from the characteristicsof P-Competition.In a Monopoly there is just one seller of a good or service forwhich there is no close substitute.In an oligopoly there are two or more, but only a few firms.In Monopolistic Competition, the products are not homog-enous but are “differentiated.”We don’t have a standard model for “insufficient knowledge”but, at least in some cases, that seems to work similarly to“product differentiation.”
18.4 The Competitive FirmOur next step is to explore the operation of a firm in a P-Competitive industry. To be specific, what does the demandcurve for the individual firm look like?You have already noticed, some time back, that the individualfirm’s demand curve is different from that of the industry, andis more elastic. This is because substitutes increase elasticity, andthe customer of the firm has many good substitutes for thatfirm’s output — namely, the output of other firms in theindustry.Now lets move to the firms statistics in P-Competitive market.
18.5 Firm Demand in P-CompetitionSince a P-Competitive structure is an idealization of thesetendencies, we say that the demand curve for a P-Competitivefirm is infinitely elastic.In fact the demand curve for a P-Competitive Firm is ahorizontal line corresponding to the going price.And that makes sense, because the price in a P-Competitivemarket is determined by supply and demand — not by theseller or the buyer. Conversely, so far as the seller or the buyer isconcerned, the price must be a given, since it is determined bysupply and demand. The seller has no control over the price,
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and to say that the seller has no control control over the price isto say that the price is given — a constant, a horizontal line —from the point of view of the seller.Economists sometimes express this by saying that the price is“parametric,” meaning that while it may change from time totime, it does not change in response to the firm’s outputdecision.
18.6 Firm Supply and DemandHappily — but not by coincidence! — all of our examples ofprofit maximization to date are based on the assumption ofgiven prices. Thus, we already know that the supply curve of aP-Competitive firm is the firm’s marginal cost curve.Thus, marginal cost = price is the same as quantity supplied =quantity demanded for the individual firm.When marginal cost = price for each firm in the industry, wehave quantity supplied = quantity demanded in the industry asa whole.
Here’s a picture:
Figure 18.1In the figure, the lower case q, s and d refer to output, supplyand demand from the point of view of the individual firm,respectively, and the capital S, D, and Q are for the industry as awhole. Cost and supply curves are shown in red and demandcurves in green. Price (per unit sold) is the same from all pointsof view.
18.7 Profits and EntryWe notice that, in the picture just shown, the firm is making an“economic profit.” All costs, explicit and implicit, are includedin the firm’s Average Cost curve. In particular, Average Costincludes the opportunity cost of capital investment — soanother way of putting it is that investors in this industry aremaking more than their best alternative investment in any otherindustry.These profit opportunities will attract new firms into theindustry. With “free entry,” the (short run) supply curve of theindustry shifts to the right, causing the price to drop until theeconomic profits are eliminated.This process of entry and price change is known as the “longrun equilibrium process” and it continues until “long runequilibrium” is attained. Here is a picture of the firm andindustry in “long run equilibrium:”
Figure 18.2The new price, quantity, firm demand and short run supply areindicated by primes — p’, q’. Q’, d’, S’. We see that, at a slightlylower price, the individual firm is lower on the MC curve andproduces a little less, but since there are more firms in theindustry, the industry as a whole produces more.
18.8 P-Competitive Equilibrium as anIdeal
Figure 18. 3We notice something else about the long-run equilibrium of aP-Competitive industry: each firm chooses the plant andequipment and productive capacity that gives the lowest averagecost overall. This is shown by the above figure.To see what this means, we might ask the following hypotheti-cal question:• If an industry is to produce a certain amount of output,
how should the output it be divided up among the differentfirms?
• More specifically, how many firms should share thatproduction assignment?
If there are very many firms, then each will be producing at avery small scale. They will not be taking advantage of theeconomies of scale, and cost per unit will be high. On the otherhand, if there are very few firms, each will be producing on avery large scale, and suffering from diseconomies of scale, so,again, unit costs would be high. It would be best to balance thedisadvantages of too large scale against the disadvantages oftoo small scale, and have just enough firms in the industry sothat each is at the bottom of its average cost curve. The totalcost of producing that output is then at a minimum.
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What we see is that the equilibrium in a P-competitive industrydoes just that. That is one reason why economists often thinkof P-competition as an ideal.Remember the assumption behind this whole argument! Theassumption is that the long run average cost curve is u-shapedas shown. There may be some industries for which that is nottrue, and the argument would not be applicable to thoseindustries.
18.9 Points About Long Run EquilibriumWe have seen that profits will lead to the entry of new firmsinto a P-competitive industry. This also works in the oppositedirection: if firms in the industry were taking losses, supply inthe industry will decrease. Firms in the industry might continueto produce in the short run, despite the losses. Remember thata profit-maximizing firm will continue to produce, in the shortrun, so long as it can cover its variable costs. However, in thelong run, firms will drop out of the industry, if they continueto lose money. Thus, the supply curve of the unprofitableindustry will shift to the left. But that in turn means prices willrise, and the long run equilibrium comes where the price is equalto average cost, as shown in Figure 18.2.This discussion could apply to any economic activity to whichthere is “free entry.” Economic profits — profits over andabove the opportunity cost of capital — will attract newentrants. Returns less than the opportunity cost of capital willcause firms to get out of the industry. This will continue untilthe return to capital in that activity is the same as the opportu-nity cost of invested capital, that is, until profits are zero.We might call this principle “the Entry Principle.” It says thatIn the long run, with free entry, returns to invested capital in anindustry are just enough to offset the opportunity cost. Whenthere are economic profits or losses, entry into the industry orexit of firms from it will shift the industry supply untileconomic profits are zero.
18.10 Long Run Supply 1We can use these principles to explore the long run supply curveof the industry. Remember, in the short run, the capital plantand productive capacity of the industry is given, and theindustry is made up of a certain group of firms. But in the longrun, all of these things are variable. By definition, capital plant isvariable in the long run — in fact, all inputs are variable. Andthe number and identity of the firms in the industry is variable.As we have just seen, economic profits will bring more firmsinto the group, and losses will result in the exit of firms. AlfredMarshall expressed this by saying that a competitive industry islike a forest, and the firms are like the trees. A forest does notgrow by having bigger trees, but by having more trees. Andsimilarly, a competitive industry grows or shrinks primarily byhaving more or fewer firms.Let’s consider a simple case. The simplifying assumptions are1. All firms have identical cost curves2. The cost curves are u-shaped as shown in Figure 18. 33. The cost curves remain stationary as the number of firms in
the industry changes
Now, let’s look at Figure 18. 4. We start out in long runequilibrium with 10,000 firms producing a total output of Q1.Short run supply and demand curves are not shown. Theaverage and marginal cost curves shown represent approxi-mately those for the 10,000th firm with respect to itscontribution to industry output, after the other 9999 firms haveproduced their parts. (These cost curves are very exaggerated.Drawn to scale they would be invisible).
Figure 18.4Now suppose there is an increase in demand (not shown) sothat the price rises above p e. The existing 10,000 firms will enjoyeconomic profits. These profits will attract new firms, so thenumber of firms in the industry will grow, shifting the shortrun industry supply (not shown) to the right and thus depress-ing the price back toward p e. When will these new entries stop?Only when economic profits are back to zero. We suppose, forthe example, that this happens when there are 15,000 firms inthe industry, producing Q2 of output. As the (exaggerated) costcurves for the 15,000th firm show, the price will be back at p e.What this example shows us is that
The long run supply curve in this case is a horizontal line corresponding tothe bottom of the average cost curve of a firm in the industry.
This is a bit of a surprise. We have been thinking of supplycurves as being upward sloping — but as we noted, there aresome exceptions. In the long run, supply may or may not beupward sloping.But first, let’s define the long run supply curve a little morecarefully.
Long Run SupplyFor each industry output, the long run supply curve shows thelowest price at which that output can be produced, so that theprice covers all costs including the opportunity cost of investedcapital.Thus the long run supply curve is a boundary — the boundarybetween profitable and unprofitable prices, given industryoutput.We have seen that, on the simplifying assumptions:1. All firms have identical cost curves2. The cost curves are u-shaped3. The cost curves remain stationary as the number of firms in
the industry changes
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the Long Run Supply curve (LRS) is a horizontal line. Ineconomics, this special case is known as a constant costindustry, for reasons that are probably pretty obvious. Butthese simplifying assumptions can’t always be applied. As-sumption 3. is the tricky one. For example, agriculturalindustries would pretty clearly be exceptions to it.Suppose, for example, that the demand for wheat increases, sowheat farming becomes profitable. Then more farmers switchfrom producing other crops to producing wheat. But thatincreases the demand for the best wheat land, so the rental costof that land increases. New farms will have to pay the higherrental cost or make use of land that is less well suited toproducing wheat. Either way, the new firms will have highercosts. Thus, the cost curves will shift upward as the number ofwheat farms increases, and the new long run equilibrium pricewill be higher. Agricultural industries are not constant costindustries, but increasing cost industries.For an increasing cost industry, the long run supply curve isupward sloping. Some economists believe there are alsodecreasing-cost industries, with downward-sloping long runsupply curves. However, we will leave these complications for acourse at a more advanced level.Instead, let’s look at another example of long run supply in aconstant-cost industry: computer software.I don’t really know for sure that computer software is aconstant cost industry. One problem is that computer programsare not identical, so we would have to measure the output ofthe industry in some uniform units. Perhaps, to a roughapproximation, the output can be measured in lines of code.Of course, not all lines are equal — some lines are wasted andsome are inspired — but this measure may work OK on theaverage, and, in fact, businessmen do use lines of code as ameasure of programmer output.Let’s assume, for the sake of the example, that software outputcan be measured on the average by lines of code and that theindustry is a constant-cost industry. The example is illustratedby Figure 18. 5:
Figure 18.5In the diagram, the long run supply of computer software isthe gray line LRS. At the beginning, we have long run equilib-rium at p e and Q1. Demand is D1 and short run supply is S1.
Now a breakthrough in computer hardware, a complementarygood, increases the usefulness of computer software and soincreases the demand for software. (The invention of desk-topcomputers pretty clearly had this effect). In the short run, theprice of computer software rises to p t with Q2 lines of softwareproduced. At this price, software is a profitable industry — theprice is above the long run supply curve, which, by definition, isthe boundary between profitable and unprofitable prices. Thus,there will be entry into the software industry (and moreprogrammers and software engineers will be trained, aninvestment in human capital) so that the short run supply curveshifts to the right. The shift continues until the new long runequilibrium is reached at price p e and production Q3, with shortrun supply S2.This two-stage adjustment process is characteristic of industriescharacterized by free entry and supply-and-demand pricing.
18.11 SummaryThe conduct and performance of an industry will depend tosome extent on its structure. Among four major types ofstructures recognized by economists we have focused on the P-Competitive — sometimes called Perfectly or PurelyCompetitive — structure as the one corresponding most closelyto the supply and demand model. This structure can bedescribed by four basic characteristics:• Many buyers and sellers• A homogenous product• Sufficient knowledge• Free entryAll of these characteristics push an industry toward predomi-nant price competition, so P-competitive could also stand for“price-competitive.” In the short run, the P-competitiveindustry’s supply curve is its marginal cost curve. In the longrun, entry of new firms and exit of firms already in the industrywill lead to a price corresponding to average cost, inclusive ofthe opportunity costs of capital and other resources. In otherwords, there are no “economic” profits. We also have foundthat the P-competitive model defines a kind of ideal in whichrational self-interest leads to an allocation of resources in whichgiven quantities of outputs are produced by enterprises of anefficient cost-minimizing scale. This remarkable finding is onemodern counterpart to Adam Smith’s conception of the“invisible hand.”Now when you are aware of perfect competition lets move toimperfect competitions.
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LESSON 19:MONOPOLY
In this chapter we consider the workings of an industry inwhich there is no possibility of competition among sellers: amonopoly.
19.1 What is a Monopoly?We have seen that P-Competition has some remarkable results.As we have seen, P-competition defines an ideal marketstructure in two senses: 1) in P-competition, price competitiondominates all other forms of competition and forces the priceto the supply-and-demand equilibrium, and 2) at that price andthe corresponding output, marginal benefit is equal to marginalcost, so the allocation of resources is efficient — net benefits aremaximized.But it seems unlikely that all industries are P-competitive, evenapproximately. We expect to find P-competition in industriesthat (among other characteristics) have many small sellers. Butwe observed some industries (cable TV, for example) in whichthere is only one seller in a particular local market, and otherindustries in a whole spectrum from one to few to many sellers.P-competition is the many-small-sellers extreme of thatspectrum.Now we consider the opposite extreme: a monopoly. Bydefinition, a monopoly is the only seller of a product for whichthere is no close substitute. It is an industry in which there isonly one firm — or., conversely, a firm that has the wholeindustry to itself.Once you know what is a monopoly, you need to know theCauses of MonopolyMost economists regard monopoly as an exceptional case in amodern economy. In an economy populated by alert profit-seekers, it seems that any profitable monopoly would quicklyattract competitors. For a monopoly to be stable, there must besome “barrier to entry.” The assumption of free entry into theindustry must not apply. Thus, we ask what might create theexception — what might “cause” a monopoly, what the “barrierto entry” might be.Most texts give four causes of monopoly, which I will also giveand add a fifth.• patents and other forms of intellectual property• control of an input resource• government• decreasing cost• crimeWe will discuss these five causes in turn.
19.1.1 Patents and Other Forms of IntellectualProperty
Patent law is designed to increase the incentive to invent newmethods of production and new goods. The inventor isgranted a temporary monopoly on the use of the invention.
The idea is that the patent makes the invention more profitable,during the term of the patent, and that these profits encourageinventors and so increase the rate of technical progress.For example, the Polaroid company has owned the basicpatents on instant cameras. When the Kodak companyproduced instant cameras in competition with Polaroid, a courtfound that this violated Polaroid’s patent rights, and Kodakhad to cease and desist and pay a penalty to Polaroid.Other forms of “intellectual property” include copyrights onbooks and works of art and such, trade-marks, and tradesecrets. Copyrights and trade-marks probably do not createmonopolies in and of themselves. There may be close substi-tutes for copyrighted books, and close or even perfectsubstitutes can be offered for trade-marked goods, providedthey do not falsify the trade-mark. However, it is possible thattrade secrets might create monopolies. The formula for Coca-Cola, for example, is a trade secret. While Coca-Cola probably isnot a monopoly, this is a matter of degree — Coca-Cola is adistinctive product. Whether other colas are close substitutes ornot we leave to the judgment of the reader.
19.1.2 Control of an Input ResourceProducts which require a natural-resource input may bemonopolized if one supplier can get control of all knownsupplies of the natural resource. For example, at one time allknown supplies of nickel were controlled by a single company.Aluminum ore, too, was at one time controlled by a singlesupplier.
19.1.3 Government Grants of Monopoly
Monopolies can be created by legislation. Historically, this hasbeen an important source of monopolies as, for example, amonarch might grant a monopoly of wine to a favorite. In themodern world, governments may still encourage monopoly inmany countries of the world, though this seems less commonas time goes on.
19.1.4 Decreasing CostsMonopolies can come about because there are decreasing costs(increasing returns to scale) in the long run. In such a case, thelong run average cost slopes downward, as shown in thepicture:
Increasing Returns to ScaleIn such a case, the largest producer can undersell the rest, andstill make a bigger profit. Therefore, in an industry in whichthere are increasing returns to scale, we would not be surprisedto find a monopoly, in the absence of any other causes. Such acase is called a “natural monopoly.”
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We will consider this case in some detail later in the chapter.
19.1.5 CrimeWhile economists usually limit themselves to discussion oflegal activities, it is clear that criminal coercion can preventcompetition and so create monopolies. This is probably mostcommon in activities that are anyway illegal, such as gambling,which often seem to be local monopolies. (It’s hard to be sure,for obvious reasons, and probably pretty changeable, too).Once established in illegal activities, criminals may use theirprofits and means of coercion to monopolize businesses thatare legal, in principle, such as small scale lending. A possibleexample is so-called “loan sharking.” The “loan shark” makesrisky loans, which is legal in itself, but limits his risk by usingthe threat of violence (which is not legal) to limit the risk andassure that the loan and interest are paid. High interest rates willbe charged, and these may be illegal. When there is a high riskof default, loans will be supplied only at very high interest rates,legal or not. But, if the loan shark uses coercive threats tomaintain a monopoly of these risky loans, the rate of interestmay be even higher than the risk of default requires, because ofa monopoly mark-up
19.2 Monopoly DemandThe demand curve for a monopoly is different from that of aP-Competitive firm.In P-competitive industry, we have to distinguish between theindustry demand and the demand for the output of anindividual firm, which are quite different. As we recall, the P-competitive firm has a horizontal demand curve. More general,if there are two or more firms in an industry, we have todistinguish between the industry demand and the firmdemand. But in a monopoly — an industry with only one firm— there is no such distinction.The demand curve for the monopoly is the demand curve forthe industry — since the monopoly controls the output of theentire industry — and the industry demand curve is downwardsloping. So the monopoly’s demand curve is downwardsloping, That means the monopoly can push the price up bylimiting output. If the monopoly cuts back on its output, it canmove up the industry demand curve to a higher price.To illustrate what this means, let’s “tell a story” about mo-nopoly. In this story the monopoly will be created bylegislation.The story begins with a competitive industry consisting ofmany firms. As usual we will call it the “widget” industry.Economists often use the word “widget” meaning “some smallgood or service, not specific.” (This came from a 1950’s musicalcomedy, “How to Succeed in Business Without Really Trying.”)You won’t be far off if you think of it as a small manufacturedgood.We’ll need to make a few simplifying assumptions. Assump-tion: Each firm operates under constant costs in the long run.We recall that with constant costs in the long run, each firm’slong run average cost is a horizontal line. We need two morefacts about constant costs in the long run, and one moreassumption.
Fact: with constant long run costs, the firm’s long run marginalcost is also a horizontal line, identical with the LRAC curve.Assumption: the firm cost curves remain the same as thenumber of firms in the industry increases.Fact: when the assumption is true, the long run average cost,marginal cost, and supply curve of the industry are also thesame horizontal line.With these assumptions, the competitive industry’s supplycurve is a horizontal line. The discussion would be a little morecomplex in general, allowing for more complicated supplycurves, but the overall results would be the same.Here is a picture of long run supply and demand under theseassumptions. In the picture, it is assumed that the constantaverage cost for the widget industry is $40 per unit, so the longrun supply curve is the horizontal red line at $40, while theindustry demand is the downward sloping green line.
Figure 19.1As we see, the long run equilibrium output for the widgetindustry is 21,000 units of output at a price of $40.Here, in Table 19.1, are the numbers for the example.
Table 19.1
Price Quantity
100 0
97 1000
94 2000
89 4000
83 6000
77 8000
71 10000
66 12000
60 14000
54 16000
49 18000
43 20000
37 22000
31 24000
26 26000
20 28000
14 30000
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Now we go on to the next stage of our story.The national legislature passes a law limiting competition in thewidget industry. All the small firms in the industry are consoli-dated into one large corporation. The owners of the oldcompetitive firms are issued shares in the corporation propor-tionate to their ownership in the old firms. The corporation isnow the only firm allowed to supply the widget industry.The board of directors of the widget industry now meet toconsider their policy, and they aim at maximizing profits. Howwill they go about this?In general, the logic of monopoly profit maximization is verymuch like the logic of the other “maximization” questions wehave dealt with. We want to use the marginal-cost, marginal-benefit logic to solve it.But it is different from the P-competitive firm, because the priceis no longer fixed, from the point of view of the monopoly.Of course, the monopoly will charge “all the market will bear,”that is, will choose a price and output on the demand curve.But that doesn’t tell us much. Starting at the competitiveequilibrium price of $40, the monopoly will raise its price toincrease its profits, but its quantity sold will drop with each priceincrease. Eventually, its profits will begin to decline because thelost sales offset the higher prices. How far up will the mo-nopoly push the price?To solve that problem, we need one more concept: marginalrevenue.
19.3 Marginal RevenueWe can define marginal revenue by a formula that should befamiliar by now, at least in its broad outlines.
where R is revenue (that is, price times quantity sold) and Q isthe quantity sold. As usual, this is an approximative formula,and the smaller the change in Q the better the approximation.We can interpret marginal revenue as (approximately) theincrease in total revenue as a result of selling one more unit ofoutput. Here’s an example of calculation of the approximation:suppose output increases from 10000 to 11000 and revenueincreases from 754286 to 714286. Then we have
Thus, between 10,000 and 11,000 units of output, the marginalrevenue is approximately $40.
19.3.1 Monopoly, P-Competition, and MarginalRevenueHere is a difference between monopoly and P-competition. Forthe P-competitive firm, the marginal revenue is the same as theprice, since each unit sold will add the price to revenue. For themonopoly, it is different. In order to sell one more unit, themonopoly has to drop its price a bit. The additional unit soldwill add something to revenue, but the cut in price will decreasethe revenue from the units the monopoly could have sold atthe old price, without cutting. So the net addition to revenuewill be less than the price at which the additional unit is sold,
and could even be negative — the lost revenue from the pricecut could be more than the price for which the additional unit issold.For example, suppose the monopoly is selling 11,000 widgetsat $69 each. This gives a total revenue of $759,000. In order toincrease sales to 13,000, the monopoly has to reduce its price to$63. The price of $63 applies to the first 11,000 units as well asthe remaining 2000 — all units of output are sold at the samemarket price. So 11,000 units at $63 per unit yields only$693,000. This is more than made up by the $126,000 earnedfrom selling 2000 more units at $63, leaving a total revenue of$819,000 — an increase in revenue relative to the $759,000 themonopoly started with, but the increase is not in proportion tothe additional sales.
19.3.2 Marginal Revenue Example: TableHere is a table of the output, price and marginal revenue in ournumerical example for this chapter. Notice that the marginalrevenue drops much faster than the price, and in fact is negativewhen the price is $40 or more.
Table 19.2Output Price Marginal Revenue0 0 971000 97 893000 91 775000 86 667000 80 549000 74 4311000 69 3113000 63 2015000 57 917000 51 -319000 46 -14
19.3.3 A Picture of Demand and Marginal RevenueHere is a picture of demand and marginal revenue for ourexample, based on the data in the previous table. Demand isshown in the darker green, and marginal revenue in the lighter.
Figure 19.2
19.4 Monopoly Profit MaximizationThe rule for monopoly profit maximization will come as nosurprise. It is
MR=MC
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That is, the rule says that the monopoly should increase outputup to the level where the marginal cost curve intersects themarginal revenue curve, in order to maximize its profits. Theprice charged is the corresponding price on the demand curve.Notice that this is a two-stage analysis:• at the first stage, the marginal cost, shown in red, and the
marginal revenue, shown in light green determine theoutput. Profit maximizing output is the output at whichthey intersect, shown by the gold line.
• at the second stage, the output and the demand curvedetermine the price. Trace up the vertical gold line to the darkgreen demand curve, and that’s the profit-maximizing price.
The diagram is a little more complex. Here it is:
Figure 19.3The output that corresponds to maximum profits is Q’,which is 10,500 widgets, and the monopoly price is $70 perwidget.
19.4.1 Monopoly Output Restriction
In the diagram, the monopoly maximizes its profits by sellingQ’.Now, let’s get back to our story. Recall, the widget industry hadbeen monopolized by an act of the legislature. Before it wasmonopolized, it had sold 21,000 units at a price of $40 — tothe right where demand crosses the marginal cost line. Now, wesee the monopoly selling much less. In fact it will sell just halfwhat the competitive industry sold — 10,500 units, at a price of$70.(It will not be this simple as a rule. Remember, we have made alot of simplifying assumptions to get here. What we can besure of in general is that a profit-maximizing monopoly willsell less than the supply-demand output, at a higher price).
19.4.1 Monopoly ProfitsIn our example, the widget industry started out in long runequilibrium, with zero economic profits. Once the monopolyhas cut back to its long run equilibrium, at a higher price, it willhave positive economic profits. In the picture below, profits areshown by the shaded blue area. The amount of monopolyprofit in this simple example is $30 (the mark-up over $40 ofcost per unit) times 10,500 widgets sold, or $315,000.
Figure 19.4
19.5 Monopoly InefficiencyThe restriction of output by the monopoly is inefficient. Thisinefficiency is shown in the following figure:
Figure 19.5We can explain the inefficiency of monopoly by using theconcept of consumers’ surplus, using the diagram. There arethree areas, the lightly shaded area above the profit rectangle, thelightly shaded area to its right, and the profit rectangle itself.Before the industry is monopolized, consumers buy 21,000widgets at $40 per widget and their consumers’ surplus is thesum of the three areas. After the monopolization, the consum-ers buy 11,500 widgets at $70, and their consumers’ surplus isthe area of the upper triangle.Let’s add up the benefits of monopolization. After monopoli-zation, the net benefits from widget production have twocomponents: the profit rectangle plus the upper consumers’surplus triangle. But the opportunity cost of monopolizationis the consumers’ surplus the consumers would have enjoyed ifthey had continued to buy at $40 — the sum of the three areas.Thus, the benefits of monopolization are less than the costs,and the difference — the excess cost — is measured by the areaof the (red) triangle to the right.This loss of consumers’ surplus is called the “deadweight loss”(meaning the monopoly profits are not enough to offset it) orthe “welfare triangle” and is a measure of the waste due tomonopoly restriction of output. In this very simplifiedexample, it is half of the monopoly profits.
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19.6 Complications in the Theory ofMonopolyBut there are still some complications we have not takenaccount of. So far we have been assuming that the monopolyhas the same cost conditions that a competitive industry wouldhave. The complications arise when the monopoly and acompetitive industry cannot have the same cost conditions.This could happen for two reasons.The monopoly, lacking the spur of competition, wastesresources so that its cost curves are above those of a competi-tive industry. The term for this is “X-Inefficiency.”This is a deviation from the neoclassical assumption ofabsolute rationality, but perhaps a very important realisticdeviation. A good deal of observational evidence suggests thatdifferent firms can have quite different costs, in what seem to bethe same circumstances. Competition, driving prices down, willtend to eliminate this problem — by eliminating the high-costfirms. In the absence of any competition at all, we would expectcosts to be higher than they would be in a competitive industry.There is some evidence that this is true.There are economies of scale, so the monopoly, operating on alarger scale, can achieve lower costs.This is the case of natural monopoly. We will explore it in a bitmore detail.
19.7 “Natural” Monopoly“Natural” monopoly creates a dilemma for neoclassical econom-ics and (perhaps) for market economies.Here is a picture-example of “natural” monopoly. The exampleassumes that there is one indivisible cost, but that once it ispaid, the firm can produce an unlimited amount at a constantmarginal cost. Thus, the Long Run Marginal Cost is horizontal,but the Long run Average Cost is downward- sloping
Figure 19.6The dilemma is that output Q1, where MC=price, is still theefficient output. But at that output, the monopoly cannot coverits total costs. On the other hand, a profit-maximizing mo-nopoly will produce much less, at Q3, which covers costs but itinefficient.In different countries and at different times, governments havedealt with this problem in three primary ways:• Government Ownership• Regulation
• Deregulation
19.7.1 Government OwnershipGovernment ownership has been a pretty common responseoutside the United States, and there are cases of municipalownership in the US.Government ownership could, in principle, solve the problem,since the government could operate the monopoly efficiently,charging a price equal to marginal cost, and cover the losses outof tax revenues.In practice, however, government monopolies usually seem tohave been operated as “cash cows” for the government, andthat’s not a solution to the problem of high monopoly prices!It has been quite common around the world (for example) forpublic telephone monopolies to raise the price of telephoneservice to pay the deficit of the postal system. Poor telephoneservice at a high price is the predictable result.In recent years, many of these government monopolies havebeen privatized.
19.7.2 RegulationIn the United States, for most of the 20th Century, the mostcommon response has been regulation. In this system, a privatemonopoly is recognized and protected as such, on the condi-tion that it keep its price down below the profit-maximizinglevel. The monopoly would be allowed to earn a “fair rate ofreturn.”Over the years, this was more and more interpreted as meaningthat the monopoly would operate at Q2, where the price justcovers average cost. This is less efficient than Q1, but better thanQ3. However, there are some other complications that ledeconomists and regulators to question this interpretation by the1960’s. In recent years, the trend has been away from regulation.
19.7.3 DeregulationNatural monopolies are complex businesses, with differentlines of business and different cost conditions for the differentlines of business, and changing technology may change the costcurves, making more competition possible. The telephoneindustry provides some examples. The Bell monopoly of the1970’s offered both long distance and local service, as well assome other lines of business. Microwave technology and othertechnical developments were making it possible for smallerfirms to compete with Bell in long distance service. But, so longas Bell remained under “natural monopoly” regulations, all itslines of business were interdependent and had to be regulatedin complicated ways.This led some economists to argue that, even in naturalmonopoly conditions, it is best to rely more on market forcesand less on government. Under the influence of those econo-mists, US natural monopolies have increasingly been“deregulated.” This began with the Jimmy Carter administra-tion (1977-80) and has been continued since by alladministrations, Republican or Democratic.Deregulation has not meant that all regulations were eliminated,but their scope has been cut back a great deal. At a minimum,the companies have had more freedom to set their own prices,
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while in most cases they are no longer protected from newcompetition.
19.7.4 Deregulation as Market-Based RegulationIt is not clear that “deregulation” has really reduced the scope ofregulation of “natural monopolies.” In practice, what emergedin the 1990’s might be better described as market-basedregulation. The nature of the regulations have changed in waysthat are designed to encourage, rather than restricting, pricecompetition.This is illustrated by a recent court decision. Michael Weinstein, acolumnist for the New York Times, writes (January 28, 1999, p.C2) that the supreme court in January upheld Federal Commu-nications Commission regulations that had been challenged bythe local telephone service providers in some parts of theUnited States. The regulations were designed to encourage newcompanies to enter the local markets to compete with the BellTelephone Companies and other local providers. Free entry,remember, is a key characteristic of price-competitive markets.“The problem was that no company was in a position toprovide local service using only its own equipment. Entrantswould need to use, at least initially, some or all of their of theBell network, including wires into homes, switching equipmentand operator services.” Weinstein quotes Gene Kimmelman, aConsumers’ Union representative, as saying that the FCC hadimposed “smart rules that compel the Bell companies tocompete on fair terms with their rivals.” The rules required thatthe local providers lease their physical facilities to the newentrants and limit the price they can charge. “... under thecommission’s rules, the Baby Bells would charge enough tocover legitimate costs — the costs of a low-cost provider — andnot one penny more.” Similar rules have been imposed on localproviders of electrical power in some areas, including thePhiladelphia region.The local service providers had argued that they should not beforced to help their competitors by allowing them to use thephysical facilities which are the property, not of the newentrants, but of the established local providers. They arguedthat this was against the spirit of deregulation and perhapsagainst the constitutional protection of private property.However, the FCC argued that a failure to require the localproviders to rent their facilities at a controlled price “posed thedanger that the Bells would exploit the 1996 act to dominatetelecommunications markets, making a mockery of Congress’will.”Once again we see the dilemma of natural monopoly. It may bethat the new sort of regulations, designed to make the telecom-munications and other “public utility” markets function morelike price-competitive markets, will be more effective in the longrun than the old sort, that tolerated the monopoly so long as itdid not raise the price too high. But the idea that we can get ridof regulation and rely on the spontaneous forces of competi-tion seems as far away as ever
19.8 Summary on MonopolyMonopoly provides an important example of an exception tothe Fundamental Principle of Microeconomics, in that there is
not enough competition to push the price down to the supply-demand level. Indeed there is only one seller.We have seen that a profit-maximizing monopoly will• produce less than a comparable P-competitive industry• charge a higher price• this output restriction is inefficientHowever, if there are economies of scale, P-competition maysimply not be possible, and the extreme case of “naturalmonopoly” leaves us with a choice of the least of three evils:public ownership, regulation, or deregulation.Now when you know both the extremes, let’s study the stuff inbetween.
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LESSON 20:IMPERFECT COMPETITION
As I have said earlier, that we will use the concepts related toperfect competition to define other market structures. Now let’sstart with the imperfect competition
20.1 Imperfect CompetitionIn the previous chapters, we have identified P-competition as anideal, in that the P-competitive structure encourages strong pricecompetition, which in turn leads to price and output at thesupply-and-demand equilibrium levels. In appropriate circum-stances, the supply-and-demand equilibrium is efficient, as theFundamental Principle of Microeconomics points out.For an industry to have a P-competitive structure, it must haveall four of these characteristics:• Many buyers and sellers• A homogenous product• Sufficient knowledge• Free entrySome industries (such as financial service industries and manyagricultural industries) seem to approximate the P-competitivestructure nearly enough that there is little doubt that the P-competitive theory can be applied to them. A few industries areequally clearly exceptions to which the P-competitive theorycannot be applied: monopolies, which we studied in the lastchapter. There seem to be a considerable number of industriesthat don’t clearly fit either extreme. The discussion of thesecases in the 1920’s and 1930’s led to a classification of industriesand markets into four major types:• “Perfect Competition”• Monopoly• Oligopoly• Monopolistic competitionWe now need to say what we can about the last two of thesetypes. “Oligopoly” and “Monopolistic Competition” areoften lumped together as “Imperfect Competition.”Here is a table to illustrate the the four characteristics of “PureCompetition” and how the four market forms differ.
Sellers Product Knowledge Entry
Pure Competition
Many Homogenous Sufficient Free
Monopoly One ? ? None
Oligopoly Few ? ? None or limited
Monopolistic Competition Many Differentiated ? Free
20.2 Forms of Imperfect CompetitionThe two recognized forms of imperfect competition are definedby the ways in which they deviate from the four characteristicsof P-competitive markets:
Oligopoly
The term “oligopoly” comes from Greek roots meaning“few sellers,” and that is the way that oligopoly differs bothfrom P-competition and monopoly — there is more thanone seller, but not “very many.” Of course, this is a vagueconception — the vagueness is unavoidable in the use of therelative term “few” — and economists have debated on theexact boundaries between “few” and “many. For the smallnumber of sellers to be stable, there presumably must besome “barriers to entry” of new competitors.
Monopolistic Competition
In monopolistic competition the products sold by thedifferent firms in the industry group are not homogenousbut differentiated. Thus, each firm has a “monopoly” of itsown product. But it is not a true monopoly, such as weconsidered in the last chapter, because the differentiatedproducts are “close substitutes.” Once again, we have acertain vagueness here: how close is a “close substitute?” Butonce again, the vagueness is in the facts, not in thediscussion: the products of real firms may be more or lessclose substitutes in different cases. For monopolisticcompetition, however, entry is free.
All of this vagueness is a bother, but the thing to keep in mindis that these are broad umbrella terms, each of which includes arange of possibilities, and that may overlap to some extent. Forexample, some oligopolies sell differentiated products. Ratherthan try to discuss these types separately, we will consider someof the characteristics that may be observed in imperfectlycompetitive markets in general, and that be more or lessimportant in different cases.
20.3 Implications of ImperfectCompetitionThe main significance of the four characteristics of P-Competi-tive structure is that they are conducive to price competition.When those characteristics are missing, we may see• increased nonprice competition• decreased price competition.We will explore these possibilities in turn. After exporing thekinds of nonrpice competition, we will explore monopolisticcompetition, a market structure associated with a great deal ofnonprice competition, then go on to discuss oligopoly, in whichreduced price competition is the central issue.
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20.4 Other Forms of CompetitionIn these other two market structures, which together are oftencalled “imperfectly competitive” structures, there may just beless competition, or there may be other forms of competition,“nonprice competition.”Nonprice competition includes• competition in the characteristics of the good
• differentiation• quality competition
• Advertising• informational• persuasive
20.5 Product DifferentiationProducts are differentiated when the products of differentcompanies are not perfect substitutes — instead, “everycompany has a monopoly of its own product.” Nevertheless,companies may compete by changing the characteristics of theproduct they sell. The idea is not necessarily to make a betterproduct than the competitor, just different — to appeal to adifferent “market niche.”Again, economists (on the whole) regard this form of competi-tion as a mixed bag:• It increases variety, thus increasing the range of consumer
choice, which is good, but• It divides up the market, leading to higher prices and costsAccording to the traditional ideas on “imperfect competition”developed in the first half of the twentieth century, this formof competition is especially common in “monopolisticcompetition.” In fact it is part of the definition of monopolis-tic competition. But is also observed in many oligopolies.
20.6 Competition in QualityIn some industries, there is a very hot competition to introducea product that is superior to rival products. This form ofcompetition has a good reputation but it can certainly beoverdone and may be overrated.Competition in quality lends itself to “horse races,” in whichonly the winner gets any profit at all, and recent researchindicates that these “winner take all” competitions tend to leadto overinvestment and waste of resources. The constantupgrading of computer software may be an example. We willtake a closer look at “horse race” competition in a later chapter.In any event, to much of a good thing — that is, spending toomuch on a good thing — can always change it into a bad thing.On the other hand, quality improvement makes consumersbetter off in an obvious and probably pretty major way, socompetition in quality is at worst a mixed bag.
20.7 Informational AdvertisingIn a P-competitive market, there is no advertising, because thereis no need to advertise — the firm can sell its profit-maximizingoutput at the market price, so why should it spend on advertis-ing? But in the real world, advertising is a very majorcompetitive strategy.
When the aim of the advertising is to give people informationabout the availability, characteristics and prices of goods, we callit “informational advertising.” This sort of advertising increasesthe consumer’s range of choice and may improve the quality ofthe decisions consumers make. It can also contribute to theeffectiveness of price competition, so (in some markets) it maycomplement price competition and bring the market closer tothe supply-and-demand outcome than it otherwise would be.The purpose of cutting your price is to attract more customers,after all. If nobody knows about the price cut, it will be lesseffective, so why bother? Conversely, an advertised price cut canbe the most powerful form of price competition.Some “professional ethics” laws have prohibited physicians andlawyers from advertising, on the grounds that such advertisingwould be inconsistent with professionalism. In recent years, aspart of the trend toward increased reliance on markets inmodern economies, those laws have been repealed in somejurisdictions. The repeal does seem to lead to increased pricecompetition.All the same, like other forms of nonprice competition,economists regard informational advertising as something of amixed bag:• It gives people information they might lack, which is good,
but• It can be overdone, spending too much on advertising and
driving prices up, which is not so good.
20.8 Persuasive AdvertisingThe purpose of persuasive advertising is to shift the utilityfunctions of the customers, thus to shift their demand curvesin favor of the good being advertised. Since we judge consum-ers’ benefits in terms of given consumer utility functions, it ishard to say if consumers benefit or lose — so persuasiveadvertising looks like spending money without makingconsumers any better off, and many economists regard that as anegative.We expect that both forms of advertising will be especiallycommon in oligopolies and whenever products are differenti-ated, as in monopolistic competition. Monopolies, too, mayfind it profitable to advertise.
20.9 SummaryWhile the various forms of nonprice competition each seems tobe a mixed bag — some good, some bad consequences —many economists feel that, on the whole, more competition inall these categories tends to be better than less competition.This is especially likely where the competition results in anincreased range of consumer choice. Common sense tells usthat choices “keep the suppliers honest,” and economic theorytells us that even when the suppliers are as honest as they couldbe, more choices can make people better off, but never worseoff — so nonprice competition, even though it has costs, canhave pretty substantial benefits that more than balance them.Let me tell you a very interesting example of garbage pickup.Garbage pickup is a rather interesting industry, in that we canfind just about all forms of economic organization in this field:
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Government OrganizationIn many localities, the garbage is hauled by public employees
PrivatizationThere are a considerable number of communities in whichgarbage is hauled by private monopolies under a contract withthe government.
Free competitionYou must have seen some people picking up garbage from roadside.
AutarkyAutarky means each person must provide the service forhimself or herself, and there are rural areas in which there isindeed no garbage pickup service at all.Now let us switch over to types of imperfect competition oneby one. First we will take up Monopolistic Competition.
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LESSON 21:MONOPOLISTIC COMPETITION
21.1 What is Monopolistic CompetitionIn discussing industries that are neither monopolies nor p-competitive, economists have tended to begin from the fourcharacteristics of a p-competitive industry. We recall that thosecharacteristics are: • Many buyers and sellers• A homogenous product• Sufficient knowledge• Free entryCompetition can be “imperfect” in an industry if the industrydeviates from any one of the four. Thus, if there are just a fewfirms (but more than one), deviating from the first characteris-tic, the industry is said to be an “oligopoly.” Since thenineteen-twenties, economists have also discussed the situationwhen an “industry” deviates only in the second characteristic.This is called “monopolistic competition,” and we have“monopolistic competition” when a group of firms sell closelyrelated, but not homogenous products. Instead, the productsare said to be “differentiated products.” Thus, the characteristicsof “monopolistic competition” are:• Many buyers and sellers• Differentiated products• Sufficient knowledge• Free entryTo say that products are differentiated is to say that the productsmay be (more or less) good substitutes, but they are not perfectsubstitutes. For an example of a monopolistically competitive“industry” we may think of the hairdressing industry. There aremany hairdressers in the country, and most hairdressing firmsare quite small. There is free entry and it is at least possible thatpeople know enough about their hairdressing options so thatthe “sufficient knowledge” condition is fulfilled. But theproducts of different hairdressers are not perfect substitutes. Atthe very least, their services are differentiated by location. Ahairdresser in Center City Philadelphia is not a perfect substitutefor a hairdresser in the suburbs — although they may be goodsubstitutes from the point of view of a customer who lives inthe suburbs but works in Center City. Hairdressers’ services maybe differentiated in other ways as well. Their styles may bedifferent; the decor of the salon may be different, and that maymake a difference for some customers; and even the quality ofthe conversation may make a difference. A very good friend ofmine changed hairdressers because her old hairdresser was anoutspoken Republican. My friend said that she just couldn’ttake it any more without answering back — and it’s not a goodidea to get into a controversy with one’s haircutter!
21.1.1 Product DifferentiationOn the previous page, the word “industry” was put in quotes,when it referred to a group of firms with product differentia-tion. That’s because the boundaries of the industry becomemuch more vague when we talk about product differentiation.A hairdresser in Center City Philadelphia and another in aPhiladelphia suburb may be pretty close substitutes — but thePhiladelphia hairdresser’s service will be a very poor substitutefor the services of a hairdresser in Seattle! Are they in the sameindustry? Or should we think of hairdressing industries aslocalized, so that Philadelphia hairdressing is a different industrythan Seattle hairdressing? And, too: barbers may cut women’shair, and hairdressers may cut men’s hair. Are hairdressers andbarbers part of the same industry, or different industries? Therereally is no final answer to this question, and some economistshave avoided any reference to industries in dealing withmonopolistic competition. Instead they talk about “productgroups.” A product group is a group of firms selling productsthat are “good,” but not necessarily “perfect” substitutes. And,of course, a product group is not unique, since it depends onhow “good” we require the substitutes to be, so there will bebroader and narrower product groups. Coke and Pepsi are bothmembers of the product group “cola drinks,” while Coke, Dr.Pepper, Sprite and Squirt are members of the broader productgroup “carbonated soft drinks.”This illustrates another point. Product differentiation ischaracteristic of monopolistic competition, but not limited tomonopolistic competition. Oligopolies, too, may have productdifferentiation. Cola drinks would probably be thought of as adifferentiated oligopoly, an oligopoly product group, rather thana monopolistically competitive group.And what about “free entry?” For monopolistic competition,that means free entry into the “product group.” Again, let’sthink of hairdressers as the example. If a hairdresser is especiallysuccessful with a Seattle-punk style at a certain location in CenterCity Philadelphia, there is nothing to prevent other hairdressersfrom setting up at a nearby location, and cutting in a similarstyle. In that sense, there is “free entry” into the product group.In general, when one monopolistically competitive firm is quiteprofitable, we may expect that other firms will set up inbusiness producing similar products, and established firms maychange the characteristics of the products they produce, to makethose products more similar to the successful one. In thatsense, there is free entry into the monopolistically competitiveproduct group.
21.1.1.1 The Short RunIn the short run, then, the monopolistically competitive firmfaces limited competition. There are other firms that sellproducts that are good, but not perfect, substitutes for thefirm’s own product. In the words of British economist Joan
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Robinson, every firm has a monopoly of its own product.When the product is differentiated, that means the firm hassome monopoly power — maybe not much, if the competingproducts are close substitutes, but some monopoly power, andthat means we must use the monopoly analysis, as if Figure 1below.
Figure 21.1: Monopolistic CompetitionWe see that, as usual in monopoly analysis, the marginalrevenue is less than the price. The firm will set its output so asto make marginal cost equal to marginal revenue, and charge thecorresponding price on the demand curve, so that in thisexample, the monopoly sells 1000 units of output (per week,perhaps) for a price of $85 per unit.But this is just a short run situation. We see that the price isgreater than the average cost (which is $74 per unit, in this case)giving a profit of $11,000 per week. We remember too that thisis economic profit — net of all implicit as well as explicit costs— so this profitable performance will attract new competitionin the long run. What that means is that new firms will set up,and existing firms will change their products, so that there willbe more, and closer, substitutes in the long run. That will shiftthe demand for this firm’s profits downward, and perhapscause the cost curves to shift upward as well, squeezing theprofit margins.
21.1.1.2 The Long RunIn monopolistic competition, when one firm or product varietyis profitable, it will attract more competition — more substi-tutes and closer substitutes for the profitable product type.Thus, demand will shift downward and (perhaps) costs willincrease. This will go on as long as the firm and its product typeremain profitable. A new “long run equilibrium” is reachedwhen (economic) profits have been eliminated. This is shownin Figure 2:
Figure 21.2In this example, the firm can break even by selling 935 units ofoutput at a price of $76 per unit. The profit — zero — is thegreatest profit the firm can make, so profit is being maximized(as usual) with the output that makes MC=MR.Zero (economic) profit is also the condition for long runequilibrium in a p-competitive industry. But this equilibrium isnot the ideal that the long run equilibrium in a p-competitiveindustry is. Many economists feel that the long run equilibriumin a monopolistic industry has some problems:
InefficiencyNotice that, either in the long run or in the short, the price isgreater than marginal cost. But the condition for efficientproduction is that price is equal to marginal cost. Thus, anindividual firm’s output is less that would be efficient, accordingto the traditional standard.
Excess CapacityWe see that, in the long run, the firm is not producing at thebottom of its long run average cost curve. Instead, it isoperating on a scale that is smaller and less efficient — the firmhas a capacity to produce more at a lower average cost. To put ita little differently, each firm is serving a market that is too small,and there are too many firms, so that the product group as awhole has the capacity to serve more customers than there are— excess capacity.
Advertising and Nonprice CompetitionA firm in a p-competitive industry will not advertise at all. Whyshould they? The p-competitive firm can sell all it wants to sell,without cutting its price, so why spend money to get morecustomers? But the monopolistically competitive firm cannotsell all it wants without cutting its price, and advertising to getmore customers may be more profitable than cutting price.Thus, economists expect to see monopolistic competitionassociated with advertising. Moreover, advertising seems to goalong with differentiated products, and as a profitable firmattracts more competition, with more substitutes and closersubstitutes for their product, the firm may feel that it needs tospend more on advertising. (That’s why the cost curve could be
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higher in a long run equilibrium). In this context, advertising isseen as wasteful.Of course, all of this is controversial. Some economists havebeen quite critical of the idea of monopolistic competitionfrom the start. Here are some responses the critics might maketo these points.
InefficiencyWhile the hypothetical monopolistically competitive firm doesoperate inefficiently, it doesn’t miss efficiency by much. Thedeviation of marginal cost from marginal price, and of thefirm’s production and price from the efficient, p-competitivequantities could be only a few percent — less than we can detectin practice. Thus, despite the differentiation of products, the p-competitive theory may be a “good enough” approximation,especially in the long run.
Excess CapacityAgain, for concreteness, let’s think of hairdressing as a typicalinstance of “monopolistic competition.” What this is telling usis that if some of the existing hairdressing enterprises werecombined, so that there would be fewer hairdressers eachserving a larger market, they could serve that market at a lowercost and price. Perhaps; but some consumers would lose out,since they would have to go further from their homes or officesto find the nearest hairdresser. More generally, getting rid of“excess capacity” means sacrificing variety — and that’s a loss.Whose favorite is to be eliminated?
Advertising and Nonprice CompetitionActually, advertising is common in most industries, however,competitive — as a disequilibrium event. When price is a littleabove equilibrium, it makes sense for a competitive firm toinclude advertising it its competitive mix; but when pricecompetition brings the price down to its equilibrium level,sellers no longer have any reason to compete for buyers —either by price cuts or advertising or any other way. In the realworld, a competitive industry is always reacting to changingevents, always moving toward the equilibrium — but it maynever stay there for very long. And this advertising is useful, inkeeping consumers up to date about their opportunities. So itis not clear that monopolistically competitive advertising issomething to be concerned about.As we have seen before, economic theory favors price competi-tion, while nonprice competition — by advertising and othermeans — is often seen as a mixed bag of good and bad. Butsome economists claim that monopolistic competitionpromotes a particularly unfortunate kind of nonprice competi-tion. Here’s the idea:
21.1.2 Increasing Product DifferentiationA monopolistically competitive firm faces competition fromother products that are good substitutes for its own producttype. One way that it might be able to improve its profitmargins is by changing its product type so that the otherproducts are less substitutable for it. This is “increasing thedifferentiation of the product” or “(further) differentiating theproduct,” and may be accomplished by creating marketing,engineering redesign, or other means.
How does “increasing the differentiation of the product” workin the model of monopolistic competition? Thinking back tothe section on elasticity, we recallThe more and the closer substitutes there are for a product, themore elastic the demand for that product is.So, if the effort to differentiate the product is successful, theelasticity of demand for the product will be decreased. In turn,we recallA less elastic demand is correlated with a steeper demand curve.So we can visualize a more differentiated product as having asteeper demand curve. That’s the idea behind Figure 21.3:
Figure 21.3In the figure, the firm has succeeded in further differentiating itsproduct, (starting from the long-run equilibrium we sawbefore) without losing any of their customers. This substitutesthe lighter green New Demand curve for the old demand curveD. As a result, referring to the new marginal revenue curve(which is not shown, to keep this complicated diagram frombeing any more complicated) the firm will maximize profits byselling 642.5 units at $110 each for profits somewhat over$70,000 at an average cost of $90 per unit. That compares withzero profits in the long run equilibrium on demand curve D —not bad!But, of course, it is still a short run gain. In the long run, thenew product type will attract new competition, and profits willagain be eroded. That’s life in a competitive business. Profits inthe short run beats no profits at all.All the same, let’s take a look at the long run.
21.1.2.1 Increasing Product Differentiation : Long RunIf the increasing product differentiation is successful inincreasing profits in the long run, it will attract new competitionuntil the economic profits are wiped out in the new long runequilibrium. Since all of the firms are trying to increase thedifferentiation of their products, the competing products arenot closer substitutes, but just because of increasing numbersof firms, demand decreases and profits disappear. Here is theway the firm’s new long run equilibrium would look:
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Figure 21.4Now we see zero profits on the new demand curve, with salesof 610 units at a price of $99 per unit. Comparing the two longrun equilibria, we see that in this case, nonprice competition hasincreased the price and cost from $76 per unit to $99 per unit,while production has been cut back from 935 units to 610 units.This doesn’t look very good for monopolistic competition.
21.2 The Controversy on Monopolistic CompetitionIt sometimes happens in the reasonable dialog of economicsthat issues are raised that cannot be fully resolved to everybody’ssatisfaction. That has been the case with the theory of monopo-listic competition. Some of the great economists of the 1920’sand 1930’s began the study of monopolistic competition.American economist Edward Chamberlin and British econo-mists Joan Robinson and Abba Lerner all made importantcontributions to the theory, while British economist RoyHarrod and American economist George Stigler criticized it. Aswe have just seen, increasing differentiation of products couldlead to nonprice competition with increasing prices and costs.Critics argued that a firm that was unwise enough to adopt thisprice-raising strategy would soon be undercut by a low-costproducer before very long; in other words, that a high-pricesituation could not be a long-run equilibrium. The critics alsoheld that the monopolistic competition theory was tooimprecise. While it may not be very easy to see, in this simplediscussion, the p-competitive theory could be restated in veryprecise ways. The theory of monopolistic competition washarder to restate in precise terms. By about 1970, it seemed as ifthe critics had won. But during the 1980’s and 1990’s, monopo-listic competition theory had made something of a comeback.Product differentiation and variety seemed to important to leaveout of economic theory, and economists found ways to makethis idea quite precise. It also seemed especially important ininternational trade: when both the United States and Germanyimport automobiles to one another, it must mean thatautomobiles are a differentiated product, and that the Americancars are different from the German cars. The problem is that westill really do not know what that implies for efficiency. Thetheorists of the 1990’s tend to put a great deal of stress on thetendency of nonprice competition to encourage innovation andthe introduction of new products, rather than any tendency toraise prices. The discussion is still going on.What we are pretty sure of is that product variety is important.But we have a lot to learn about how the market system creates
product variety, and whether it creates too much, too little, orjust about enough. Perhaps one of the readers of this bookwill discover the answer to that question.
21.3 Decreased Price CompetitionIn a P-competitive industry, in the long run, economic profitswill be zero and prices determined by supply and demand. In amonopoly, prices are higher and the industry profit is at amaximum. How high will the profits and prices of an imper-fectly competitive industry be? This issue has been discussed byeconomists for over a hundred years, and is still not entirelyresolved!Of course, the answer may depend somewhat on the structureof the industry we are looking at — remember, there is a widerange of imperfectly competitive structures. Here, we do need todistinguish between monopolistic competition and oligopoly.For monopolistic competition, there is free entry, so (as in P-competition) economic profits will be zero in the long run. Aslong as there are positive economic profits, new competitionwill be attracted into the industry group, and therefore positiveeconomic profits will not be stable in a monopolisticallycompetitive industry. However, some economists believe that amonopolistically competitive industry may have high pricesbecause nonprice competition pushes up costs.For oligopoly, we will have to consider several hypotheses.
21.3 Oligopoly PricesEconomists have been discussing oligopoly prices and profitssince the 1840’s. In principle, the oligopoly’s profits could neverbe higher than those of a monopoly — since the monopolychooses the price that maximizes industry profits. A pricehigher than the monopoly price would just reduce profits (bydriving away too many customers), so we wouldn’t expect tosee a price above the monopoly price. At the other extreme, inthe long run, no industry — and in particular no oligopoly —could be stable with prices and profits lower than those of a P-competitive industry in long-run equilibrium: zero economicprofits and the supply-and-demand equilibrium price. Butwhere in this range will the oligopoly’s prices settle?There are four major hypotheses about oligopoly pricing:1. The oligopoly firms will conspire and collaborate to charge
the monopoly price and get monopoly profits.2. The oligopoly firms will compete on price so that the price
and profits will be the same as those of a P-competitiveindustry.
3. The oligopoly price and profits will be somewhere betweenthe monopoly and competitive ends of the scale.
4. Oligopoly prices and profits are “indeterminate.” That is, theymay be anything within the range, and are unpredictable.
Unfortunately, theoretical reasoning has not been able todetermine which of these hypotheses is most likely. Econo-mists have developed models that lead to each of these fourresults. Instead of relying on theory, we will have to try todiscover the answer by observation.
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Hypothesis 3 — that oligopoly price and profits will besomewhere between the monopoly and competitive ends ofthe scale — seems to be the commonsense guess, and in thiscase commonsense seems to be right. Since the 1950’s therehave been many studies in the fields of “industrial organiza-tion” and “econometrics” (economic statistics) to try to resolvethis question. While there is room for some controversy, theweight of the evidence seems to favor commonsense hypoth-esis 3.We can go a little further. We say that an industry is moreconcentrated when it is more dominated by a few large firms —in other words, when its structure comes closer to the mo-nopoly end of the scale. One rough way to measure theconcentration of an industry is to compute the portion of theindustry’s sales revenue that is earned by the biggest four (orthree or eight) firms in the industry. This is called the four-firmconcentration ratio, and the bigger the four-firm concentrationratio, the more concentrated and monopoly-likethe industry is.There are other, more complicated ways to measure industryconcentration that take into account all of the firms in theindustry, rather than just the biggest four; but we will findindustries rank about the same for concentration however wemeasure it.Common-sense suggests that the more “concentrated” theoligopoly is — that is, the fewer and bigger the firms are, sothat it more nearly resembles a monopoly — the nearermonopoly profits and prices the industry will come. And, onceagain, the evidence of observation agrees with common sense.Here, again, there is some possible controversy, but the weightof evidence is that more concentrated industries do havesomewhat higher profits (counting interest payments as a cost).So we may think of a spectrum of industries, with competitiveindustries at one end and monopolies at the other, and witholigopolies falling at the points in between. that’s not veryprecise, but it seems to fit the facts pretty well.
21.3 Oligopoly Pricing StrategyAll the same, those who believe in the “indeterminate” theoryhave a pretty good case. It seems that traditional microeconomictheory just doesn’t have an answer to the question of oligopolypricing.In the 1930’s, it began to seem that the problem was thatoligopoly pricing decisions are strategic decisions. That isn’t sofor P-competition. P-competitive firms don’t decide on a price— they just decide how much to sell at the price determined bysupply and demand. Nor are monopoly pricing decisionsstrategic, at least in the same sense. Since the monopoly has (bydefinition) no rivals, it does not have to consider how its rivalswill respond to its decision. But that’s the essence of a strategicdecision, and oligopolists’ decisions are strategic in that sense:they have to consider the reactions of their rivals (one another).The difficulty of resolving the question of strategic pricedecisions within traditional microeonomic theory led someeconomists, around 1940, to consider a new theory of strategicdecisions that was being developed by the great mathematicianJohn von Neumann. It was called Game Theory. Over the years,game theory has become increasingly important as an approach
to microeconomic questions in general — not just in oligopolypricing. Accordingly, we will now go on to a quick survey ofgame theory, before concluding this chapter.
21.4 Game Theory BasicsGame theory is a distinct and interdisciplinary approach to the study ofstrategic behavior. The disciplines most involved in game theory aremathematics, economics and the other social and behavioral sciences.Game theory (like computational theory and so many other contribu-tions) was founded by the great mathematician John von Neumann. Thefirst important book was The Theory of Games and EconomicBehavior, which von Neumann wrote in collaboration with the greatmathematical economist, Oskar Morgenstern. Certainly Morgensternbrought ideas from neoclassical economics into the partnership, but vonNeumann, too, was well aware of them and had made other contributionsto neoclassical economics.
A Scientific Metaphor
Since the work of John von Neumann, “games” have been ascientific metaphor for a much wider range of human interac-tions in which the outcomes depend on the interactive strategiesof two or more persons, who have opposed or at best mixedmotives. Among the issues discussed in game theory are1. What does it mean to choose strategies “rationally” when
outcomes depend on the strategies chosen by others andwhen information is incomplete?
2. In “games” that allow mutual gain (or mutual loss) is it“rational” to cooperate to realize the mutual gain (or avoidthe mutual loss) or is it “rational” to act aggressively inseeking individual gain regardless of mutual gain or loss?
3. If the answers to 2) are “sometimes,” in what circumstancesis aggression rational and in what circumstances iscooperation rational?
4. In particular, do ongoing relationships differ from one-offencounters in this connection?
5. Can moral rules of cooperation emerge spontaneously fromthe interactions of rational egoists?
6. How does real human behavior correspond to “rational”behavior in these cases?
7. If it differs, in what direction? Are people more cooperativethan would be “rational?” More aggressive? Both?
Thus, among the “games” studied by game theory are• Bankruptcy• Barbarians at the Gate• Battle of the Networks• Caveat Emptor• Conscription• Coordination• Escape and Evasion• Frogs Call for Mates• Hawk versus Dove• Mutually Assured Destruction• Majority Rule• Market Niche
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• Mutual Defense• Prisoner’s Dilemma• Subsidized Small Business• Tragedy of the Commons• Ultimatum• Video System Coordination(This list is extracted from an index of games discussed in RoyGardner, Games for Business and Economics)
RationalityThe key link between neoclassical economics and game theorywas and is rationality. Neoclassical economics is based on theassumption that human beings are absolutely rational in theireconomic choices. Specifically, the assumption is that eachperson maximizes her or his rewards — profits, incomes, orsubjective benefits — in the circumstances that she or he faces.This hypothesis serves a double purpose in the study of theallocation of resources. First, it narrows the range of possibili-ties somewhat. Absolutely rational behavior is more predictablethan irrational behavior. Second, it provides a criterion forevaluation of the efficiency of an economic system. If thesystem leads to a reduction in the rewards coming to somepeople, without producing more than compensating rewards toothers (costs greater than benefits, broadly) then something iswrong. Pollution, the overexploitation of fisheries, andinadequate resources committed to research can all be examplesof this.In neoclassical economics, the rational individual faces a specificsystem of institutions, including property rights, money, andhighly competitive markets. These are among the “circum-stances” that the person takes into account in maximizingrewards. The implications of property rights, a money economyand ideally competitive markets is that the individual needs notconsider her or his interactions with other individuals. She or heneeds consider only his or her own situation and the “condi-tions of the market.” But this leads to two problems. First, itlimits the range of the theory. Where-ever competition isrestricted (but there is no monopoly), or property rights are notfully defined, consensus neoclassical economic theory isinapplicable, and neoclassical economics has never produced agenerally accepted extension of the theory to cover these cases.Decisions taken outside the money economy were also prob-lematic for neoclassical economics.Game theory was intended to confront just this problem: toprovide a theory of economic and strategic behavior whenpeople interact directly, rather than “through the market.” Ingame theory, “games” have always been a metaphor for moreserious interactions in human society. Game theory may beabout poker and baseball, but it is not about chess, and it isabout such serious interactions as market competition, armsraces and environmental pollution. But game theory addressesthe serious interactions using the metaphor of a game: in theseserious interactions, as in games, the individual’s choice isessentially a choice of a strategy, and the outcome of theinteraction depends on the strategies chosen by each of theparticipants. On this interpretation, a study of games may
indeed tell us something about serious interactions. But howmuch?In neoclassical economic theory, to choose rationally is tomaximize one’s rewards. From one point of view, this is aproblem in mathematics: choose the activity that maximizesrewards in given circumstances. Thus we may think of rationaleconomic choices as the “solution” to a problem of mathemat-ics. In game theory, the case is more complex, since the outcomedepends not only on my own strategies and the “marketconditions,” but also directly on the strategies chosen by others,but we may still think of the rational choice of strategies as amathematical problem — maximize the rewards of a group ofinteracting decision makers — and so we again speak of therational outcome as the “solution” to the game.
21.4 The Prisoners’ DilemmaRecent developments in game theory, especially the award of theNobel Memorial Prize in 1994 to three game theorists and thedeath of A. W. Tucker, in January, 1995, at 89, have renewed thememory of its beginnings. Although the history of gametheory can be traced back earlier, the key period for the emer-gence of game theory was the decade of the 1940’s. Thepublication of The Theory of Games and Economic Behaviorwas a particularly important step, of course. But in some ways,Tucker’s invention of the Prisoners’ Dilemma example waseven more important. This example, which can be set out inone page, could be the most influential one page in the socialsciences in the latter half of the twentieth century.This remarkable innovation did not come out in a researchpaper, but in a classroom. As S. J. Hagenmayer wrote in thePhiladelphia Inquirer (“Albert W. Tucker, 89, Famed Mathemati-cian,” Thursday, Feb. 2, 1995, p.. B7) “ In 1950, while addressingan audience of psychologists at Stanford University, where hewas a visiting professor, Mr. Tucker created the Prisoners’Dilemma to illustrate the difficulty of analyzing” certain kindsof games. “Mr. Tucker’s simple explanation has since given riseto a vast body of literature in subjects as diverse as philosophy,ethics, biology, sociology, political science, economics, and, ofcourse, game theory.”
The GameTucker began with a little story, like this: two burglars, Bob andAl, are captured near the scene of a burglary and are given the“third degree” separately by the police. Each has to choosewhether or not to confess and implicate the other. If neitherman confesses, then both will serve one year on a charge ofcarrying a concealed weapon. If each confesses and implicatesthe other, both will go to prison for 10 years. However, if oneburglar confesses and implicates the other, and the other burglardoes not confess, the one who has collaborated with the policewill go free, while the other burglar will go to prison for 20 yearson the maximum charge.The strategies in this case are: confess or don’t confess. Theypayoffs (penalties, actually) are the sentences served. We canexpress all this compactly in a “payoff table” of a kind that hasbecome pretty standard in game theory. Here is the payoff tablefor the Prisoners’ Dilemma game:
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Table 1
Al
confess don't
confess 10,10 0,20 Bob
don't 20,0 1,1
The table is read like this: Each prisoner chooses one of the twostrategies. In effect, Al chooses a column and Bob chooses arow. The two numbers in each cell tell the outcomes for the twoprisoners when the corresponding pair of strategies is chosen.The number to the left of the comma tells the payoff to theperson who chooses the rows (Bob) while the number to theright of the column tells the payoff to the person who choosesthe columns (Al). Thus (reading down the first column) if theyboth confess, each gets 10 years, but if Al confesses and Bobdoes not, Bob gets 20 and Al goes free.So: how to solve this game? What strategies are “rational” ifboth men want to minimize the time they spend in jail? Almight reason as follows: “Two things can happen: Bob canconfess or Bob can keep quiet. Suppose Bob confesses. Then Iget 20 years if I don’t confess, 10 years if I do, so in that case it’sbest to confess. On the other hand, if Bob doesn’t confess, andI don’t either, I get a year; but in that case, if I confess I can gofree. Either way, it’s best if I confess. Therefore, I’ll confess.”But Bob can and presumably will reason in the same way — sothat they both confess and go to prison for 10 years each. Yet, ifthey had acted “irrationally,” and kept quiet, they each couldhave gotten off with one year each.
Dominant StrategiesWhat has happened here is that the two prisoners have falleninto something called a “dominant strategy equilibrium.”DEFINITION Dominant Strategy: Let an individual player ina game evaluate separately each of the strategy combinations hemay face, and, for each combination, choose from his ownstrategies the one that gives the best payoff. If the same strategyis chosen for each of the different combinations of strategiesthe player might face, that strategy is called a “dominantstrategy” for that player in that game.DEFINITION Dominant Strategy Equilibrium: If, in a game,each player has a dominant strategy, and each player plays thedominant strategy, then that combination of (dominant)strategies and the corresponding payoffs are said to constitutethe dominant strategy equilibrium for that game.In the Prisoners’ Dilemma game, to confess is a dominantstrategy, and when both prisoners confess, that is a dominantstrategy equilibrium.
Issues With Respect to the Prisoners’ DilemmaThis remarkable result — that individually rational action resultsin both persons being made worse off in terms of their ownself-interested purposes — is what has made the wide impact in
modern social science. For there are many interactions in themodern world that seem very much like that, from arms racesthrough road congestion and pollution to the depletion offisheries and the overexploitation of some subsurface waterresources. These are all quite different interactions in detail, butare interactions in which (we suppose) individually rationalaction leads to inferior results for each person, and the Prison-ers’ Dilemma suggests something of what is going on in eachof them. That is the source of its power.Having said that, we must also admit candidly that the Prison-ers’ Dilemma is a very simplified and abstract — if you will,“unrealistic” — conception of many of these interactions. Anumber of critical issues can be raised with the Prisoners’Dilemma, and each of these issues has been the basis of a largescholarly literature:• The Prisoners’ Dilemma is a two-person game, but many of
the applications of the idea are really many-personinteractions.
• We have assumed that there is no communication betweenthe two prisoners. If they could communicate and committhemselves to coordinated strategies, we would expect a quitedifferent outcome.
• In the Prisoners’ Dilemma, the two prisoners interact onlyonce. Repetition of the interactions might lead to quitedifferent results.
• Compelling as the reasoning is that leads to the dominantstrategy equilibrium may be, it is not the only way thisproblem might be reasoned out. Perhaps it is not really themost rational answer after all.
We will consider some of these points in what follows.
21.5 Oligopoly prices and “Solutions” to PricingGamesWe are concerned in this chapter about oligopoly pricing andmarket strategy. Here is an example. It is a very simplified modelof price competition. Like Augustin Cournot (writing in the1840’s) we will think of two companies that sell mineral water.Each company has a fixed cost of $5000 per period, regardlesswhether they sell anything or not. We will call the companiesPerrier and Apollinaris, just to take two names at random.The two companies are competing for the same market andeach firm must choose a high price ($2 per bottle) or a low price($1 per bottle). Here are the rules of the game:1. At a price of $2, 5000 bottles can be sold for a total revenue
of $10000.2. At a price of $1, 10000 bottles can be sold for a total revenue
of $10000.3. If both companies charge the same price, they split the sales
evenly between them.4. If one company charges a higher price, the company with the
lower price sells the whole amount and the company withthe higher price sells nothing.
5. Payoffs are profits — revenue minus the $5000 fixed cost.
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Here is the payoff table for these two companiesTable 2
Perrier
price = $1 price = $2
price = $1 0,0 5000,-5000 Apollinaris
price = $2 -5000,5000 0,0
Once again, as in the Prisoners’ Dilemma, each company has astrong rationale to choose one strategy — and in this case it is aprice cut. For example, Appolinaris might reason “Either Perrierwill cut to $1 or it will not. If it does, then I had better cut, too— otherwise I’ll lose all my customers and lose $5000. On theother hand, if Perrier doesn’t cut, I’m still better off to cut,since I’ll take their customers away and get a profit of $5000.”Thus, the price cut is a dominant strategy.But this is, of course, a very simplified — even unrealistic —conception of price competition. Let’s look at a more compli-cated, perhaps more realistic pricing example:
Another Price Competition ExampleFollowing a long tradition in economics, we will think of twocompanies selling “widgets” at a price of one, two, or threedollars per widget. the payoffs are profits — after allowing forcosts of all kinds — and are shown in Table 5-1. The generalidea behind the example is that the company that charges alower price will get more customers and thus, within limits,more profits than the high-price competitor. (This examplefollows one by Warren Nutter).
Table 3
Acme Widgets
price = $1
price = $2
price = $3
price = $1 0,0 50,-10 40,-
20
price = $2 -10,50 20,20 90,10
Wiley Widgets
price = $3 -20,40 10,90 50,50
Unlike the mineral-water example (and more realistically),industry profits in this example depend on the price and thuson the strategies chosen by the rivals. Profits may add up to100, 20, 40, or zero, depending on the strategies that the twocompetitors choose. We can also see fairly easily that there is nodominant strategy equilibrium. Widgeon company can reasonas follows: if Acme were to choose a price of 3, then Widgeon’sbest price is 2, but otherwise Widgeon’s best price is 1 —neither is dominant.
Nash EquilibriumWe will need another, broader concept of equilibrium if we areto do anything with this game. The concept we need is calledthe Nash Equilibrium, after Nobel Laureate (in economics) andmathematician John Nash. Nash, a student of Tucker’s,contributed several key concepts to game theory around 1950.The Nash Equilibrium conception was one of these, and isprobably the most widely used “solution concept” in gametheory.DEFINITION: Nash Equilibrium If there is a set ofstrategies with the property that no player can benefit bychanging her strategy while the other players keep their strategiesunchanged, then that set of strategies and the correspondingpayoffs constitute the Nash Equilibrium.Let’s apply that definition to the widget-selling game. First, forexample, we can see that the strategy pair p=3 for each player(bottom right) is not a Nash-equilibrium. From that pair, eachcompetitor can benefit by cutting price, if the other player keepsher strategy unchanged. Or consider the bottom middle —Widgeon charges $3 but Acme charges $2. From that pair,Widgeon benefits by cutting to $1. In this way, we can eliminateany strategy pair except the upper left, at which both competi-tors charge $1.We see that the Nash equilibrium in the widget-selling game is alow-price, zero-profit equilibrium. Many economists believethat result is descriptive of real, highly competitive markets —although there is, of course, a great deal about this example thatis still “unrealistic.”Let’s go back and take a look at that dominant-strategy equilib-rium in Table 4-2. We will see that it, too, is aNash-Equilibrium. (Check it out). Also, look again at thedominant-strategy equilibrium in the Prisoners’ Dilemma. It,too, is a Nash-Equilibrium. In fact, any dominant strategyequilibrium is also a Nash Equilibrium. The Nash equilibriumis an extension of the dominant strategy equilibrium.
21.6 Cooperative Games
These three examples have the following things in common:1. In each case, there are two decision-makers.2. The payoffs to each decision-maker depends on both
decisions.3. Both decision-makers seek their own interests.4. Each chooses in isolation from the other, taking the other
decision as given.5. As a result, both have relatively bad outcomes — long
prison terms or zero profits.The Prisoners’ Dilemma has been influential throughout thesocial sciences, in the second half of the 1900’s, because it offerssuch a vivid illustration of how this can happen: rational andself-interested decision-makers, choosing their strategies inisolation from one another, find that the strategies interact sothat they both have bad outcomes.In application to the problem of oligopoly pricing, theexamples given so far seem to give strong support to thesecond hypothesis of oligopoly pricing, the hypothesis that
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oligopoly prices will be the same as those in a P-competitivemarket: zero profits. But that’s not really so clear.The key assumption in these examples is assumption 4 — thateach chooses in isolation from the other, taking the otherdecision as given. But is it really rational for them to do so? Inthe Prisoners’ Dilemma game, the isolation is imposed by therules of the game — the Prisoners have been isolated by thePolice, and have no choice in the matter. But the oligopolistscould, in principle, get together, agree on a common strategy,and share out the gains from it among themselves. Theywouldn’t be taking one anothers’ strategies as given. Instead,they would be coordinating their strategies.Of course, antitrust laws are designed to make such a price-fixing agreement illegal. But we haven’t always had antitrustlaws — they were enacted because many people believed thatbusinessmen were collaborating to fix high prices. And evennow, there may be ways to get around the law.When the decision-makers in a “game” get together, agree on acommon strategy, and share out the gains from it amongthemselves, the agreement they come to is called a “cooperativesolution” to the game. The examples we have looked at so farare “noncooperative solutions.”It appears that we cannot rule out the possibility of a coopera-tive solution to the oligopoly pricing game, so we need to looka bit at the cooperative alternative in game theory.
21.6.1 A Basic Cooperative GameIt’s not very hard to find an example of a cooperative solutionto game. In fact, we have been talking about cooperativesolutions all through this course. Buying and selling is acooperative game in which the buyer and the seller are the two“players” and the price they agree upon is their commonstrategy. Here’s a numerical example to illustrate what I mean.We suppose that Joey has a bicycle. Joey would rather have agame machine than a bicycle, and he could buy a game machinefor $80, but Joey doesn’t have any money. We express this bysaying that Joey values his bicycle at $80. Mikey has $100 and nobicycle, and would rather have a bicycle than anything else he canbuy for $100. We express this by saying that Mikey values abicycle at $100.The strategies available to Joey and Mikey are to give or to keep.That is, Joey can give his bicycle to Mikey or keep it, and Mikeycan give some of this money to Joey or keep it all. It is sug-gested that Mikey give Joey $90 and that Joey give Mikey thebicycle. This is what we call “exchange.” Here are the payoffs:Table 4
Joey
give keep
give 110,90 10,170 Mikey
keep 190,10 100,80
EXPLANATION: At the upper left, Mikey has a bicycle hevalues at $100, plus $10 extra, while Joey has a game machine hevalues at $80, plus an extra $10. At the lower left, Mikey has thebicycle he values at $100, plus $100 extra. At the upper left, Joeyhas a game machine and a bike, each of which he values at $80,plus $10 extra, and Mikey is left with only $10. At the lowerright, they simply have what they begin with — Mikey $100 andJoey a bike.If we think of this as a noncooperative game, it is much like aPrisoners’ Dilemma. To keep is a dominant strategy and keep,keep is a dominant strategy equilibrium. However, give, givemakes both better off. Being children, they may distrust oneanother and fail to make the exchange that will make thembetter off. But market societies have a range of institutions thatallow adults to commit themselves to mutually beneficialtransactions. Thus, we would expect a cooperative solution, andwe suspect that it would be the one in the upper left.Thus, we can see that cooperative solutions are not uncommonin a market society. On the contrary! They are the essence of amarket system! Thus, we cannot rule out the possibility thatoligopolists will arrive at a cooperative solution, and charge amonopoly price and get monopoly profits.
21.7 The Oligopoly ProblemIt seems that game theory doesn’t solve the oligopoly problemafter all. There are at least two kinds of solutions to theproblem of oligopoly pricing — cooperative and noncoopera-tive — and we can’t rule either one of them out.Actually, it’s a bit worse than that. In each of the two categories,there is actually more than one sort of solution, depending onhow we approach the problem! So game theory really isn’t a“solution” to the problem of oligopoly pricing at all!That had become pretty clear to economists by the 1960’s, andmany economists lost interest in game theory. But despite itsfailure on this specific point, game theory has proved to be apowerful tool of economic thinking, so that it has becomemore influential since the 1960’s, culminating in the Nobel Prizefor three game theorists (including John Nash, who inventedthe Nash-Equilibrium) in 1994.And it isn’t just simply a failure in the analysis of oligopolyprices — not really. In a comic strip a few years ago, a schoolboywas discussing his grades with his guardian. The schoolboy saidthat he had gotten an “A” on an algebra test. The guardian said,“Well, then, you must understand algebra.” “No,” the school-boy said, “but I’m confused at a much higher level.” Weeconomists can say that about oligopoly pricing.Sometimes it’s important to be confused at a higher level. Wenow understand not only that oligopoly pricing is a hardproblem, but something of why it is a hard problem. Thepricing examples we have seen here give some insight about thereason why price competition — when it does occur — is sopowerful in bringing prices down to the lowest stable level.And we can apply the same methods to a range of otherproblems, both related to imperfect competition and in otherfields of economics.Let’s try applying it to advertising, for example.
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21.7.1 AdvertisingSome economists and others believe that persuasive advertisingmay be largely wasteful. Here is an example that illustrates whatthey have in mind. We consider two whiskey manufacturers,one selling Black George brand, and the other selling WildChicken brand whiskey. If they advertise, they can sell morewhiskey, and the larger market will give them both morerevenues — but the cost of advertising more than offsets theincreased revenues, so that profits are slightly less. On the otherhand, if only one advertises, he takes most of the customersand gets a large profit. Here is the payoff table:
Table 5
Black George
advertise don't
advertise 40,40 110,10 Wild Chicken
don't 10,110 50,50
Once again, we see an outcome like the Prisoners’ Dilemma: ifeach seller takes the other seller’s decision as given, then theyboth advertise, and their profits are lower as a result. Again, asin the Prisoners’ Dilemma example, we can contrast a coopera-tive solution with this noncooperative solution. A cooperativesolution to the advertising game would be one in which thewhiskey-sellers coordinate their strategy for mutual benefit.We get these Prisoners’-Dilemma-like results because of the waythe payoffs are interrelated. Other payoff assumptions mightlead to a quite different analysis. We should stress that this is anhypothesis, not a fact. Some economists believe that advertisingis often wasteful, and explain their opinion by this Prisoners’-Dilemma-like sort of reasoning. But, so far as evidence isconcerned, the jury is still out. We don’t know whetheradvertising is a “Prisoners’ Dilemma” or not.The value of game theory, in a case such as this, is not that itanswers the questions but that it enables us to ask them moreprecisely and clearly. That’s helpful, and is a step on the way togetting the answer.
21.8 SummaryThis chapter has undertaken to survey the industries that don’tseem to fit into either the “P-competitive” or “monopoly”category: oligopolies and monopolistically competitive indus-tries, or, taking both together, imperfectly competitiveindustries. These industries deviate from one or another of thefour characteristics of P-competition, but also involve somecompetition among two or more firms selling close substitutes,if not the same products.The two major implications of imperfect competition, bycomparison with P-competition, are
Increased Nonprice CompetitionUnlike price competition, nonprice competition may be costlyand may or may not make consumers better off all in all.Nonprice competition is a mixed bag, but most economists are
persuaded that, on the whole, more competition among sellersis better than less.
Decreased Price CompetitionPrice competition favors customers and promotes efficiency, sodecreased price competition is clearly a bad aspect of imperfectcompetition. But how much will price competition be reduced?Turning to game theory, we learn that there is no one “rational”answer to the choice of price strategies in oligopoly, so thequestion cannot be given a precise answer. But there is someevidence that the intensity of price competition increases as thenumber of firms gets larger and their size gets smaller, relativeto the industry.These problems mean that the decisions of imperfectlycompetitive firms are strategic in a sense that monopolydecisions and the decisions of P-competitive firms are not.Accordingly, we have followed modern economics (andmathematics and other social sciences) in digressing a bit on animportant modern theory of strategic choices called “gametheory.” Here, too, we find not clear answers but a range ofpossibilities: the “solutions” to or equilibria in “games” may becooperative or noncooperative. The noncooperative gamessometimes lead to results that nobody wants — such as lowprices and zero economic profits in an oligopoly — but we alsohave to consider the possibility of a cooperative solution withmonopoly prices and profits.Imperfect competition remains a controversial area in econom-ics. Some economists would argue that imperfect competition isthe rule, rather than the exception, and they conclude that the“Fundamental Principle of Microeconomics” — howeverfundamental for theory — has little application in the realworld. Other economists would argue that, even if imperfectcompetition is pretty wide-spread, the deviations from supply-demand pricing in the real world are small, minor andtemporary, so that “supply and demand” remains our bestguide to prices and outputs in our market economy, with a veryfew obvious exceptions. This latter view has become morewidespread and influential over the past 30 years, and thatchange has contributed to the political climate that led toderegulation in the years since 1977.
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LESSON 22:THE ROLE OF GOVERNMENT IN THE MARKET ECONOMY
22.1 The Rationale for Regulation1. Efficiency2. Regulation3. Equity
Economic Considerations1. Market Failure2. Externalities: differences between private and social costs
or benefits. Failure by incentive. This is a situation wheresocial costs and benefits differ considerably from the privatecosts and values of producers and consumers.a. negative: a cost of producing, marketing, or consuminga product that is not borne by the product’s producers orconsumers. Environmental pollution is the best knownexample.b. Positive: a benefit of production, marketing, orconsumption that is not reflected in the product pricingstructure and, hence does not accrue to the productsproducers or consumers. The rapid acceptance of technologyin some industries which has led to reduced costs forsuppliers and hence consumers.
3. Political Considerations - play an important role in thedesign of regulatory policies:a. preservation of consumer choiceb. limit concentration of economic and political power.c. Important political considerations lead to the argumentcompelling power for government to be in themarketplace
22.2 Regulatory Response to IncentiveFailures
Operating Right Grants1. Example: FCC2. may be effective but it is imprecise3. The cost of inefficiency
Patent Grants
1. Government grants exclusive right to produce, use or sell aninvention or innovation for a limited period of time (17years in U.S.).
2. a legal monopoly - goal is to achieve the benefits of bothmonopoly and competition in the field of research anddevelopment.
3. Firms cannot use patents to unfairly monopolize orotherwise limit competition (e.g., Xerox).
Subsidies
1. provided to private business firms2. indirect - construction grants which benefit trucking3. direct - agricultural payment-in-kind programs; special tax
treatments, and government-provided low-cost financing.
Tax Policies
1. includes both regular tax payments and fines or penaltiesthat may be assessed intermittently.
2. Differentiate from subsidy and grant programs - subsidiesinfer the right to do something (pollute); taxes as a penaltyassert societies right.
Operating Controls
1. Standards - are designed to limit undesirable behavior bycompelling certain actions while prohibiting others. Limitson auto emissions as an example; fuel efficiency standards isanother. In another sector — wage and price controls tocurb inflation.
2. Relies on non-monetary incentives
22.3 Who Pays for Regulation?
1. Depends on the elasticity of demand for the final productsof affected firmsa. tax incidence vs. tax burden. The point of tax collection
versus the issue of who really pays. For example, thepolluting foundry may pay the pollution tax (incidence)but the cost may be passed onto consumers (burden).
b. Highly elastic product demand places the burden ofregulation-induced cost increases on producers.Production must be cut from Q1 to Q2
c. Low elasticity of product demand allows producers toraise prices from P1 to P2. Consumers bear the burdenof regulation-induced cost increases.
2. Problem of Underproduction
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Utility Price Regulation
1. unrestricted monopoly2. reduced dollar profit3. lower return on investment
Problems in the Utility Industry
1. Pricing problems2. Output level problems3. Inefficiency4. Investment level5. Regulatory lag and political influence6. Cost of regulation
22.4 Antitrust PolicyDesigned to promote competition and prevent unwarrantedmonopoly. The laws seek to improve economic efficiency byenhancing consumer sovereignty and the impartiality or resourceallocation while limiting concentrations in both economic andpolitical power.
Sherman Act of 18901. forbade contracts, combinations, or conspiracies in restraint
of trade.2. too vague.
Clayton Act of 1914
1. addressed problems of mergers, interlocking directorates,price discrimination, and tying contracts.
2. focused on price discrimination
22.5 The Regulatory Mess1. Cost of regulation2. The size-efficiency problem3. Capture Theory: an economic theory which suggests that
industry seeks regulation to limit competition and to obtaingovernment subsidies.
4. The deregulation movement
22.6 Price ControlsWhen markets are free to choose a price and quantity, the resultis an equilibrium. Prices become the mechanism that directsdemanders and suppliers toward this point. If, in the opinionof government decisionmakers, the resulting equilibrium priceis too high or too low, then the government may intervene inthe market by imposing price controls. Those controls are thenenacted to prevent prices from falling into unacceptableranges. Of course, normative concerns like fairness are arbitraryand represent something that government must define. Thatis, government must decide exactly how high is too high orhow far a price can fall before it’s too low.Price controls are important because they can alter the behaviorwithin a market. Prices act as an incentive to buy and sell. Forexample, if government deems a price too high, then it ispossible that the government may restrict the price from risingabove a certain point by placing a price ceiling on the good soldin this market. The price ceiling serves as a price maximum.
Similarly, if the price was too low, then the government couldimpose a price floor (price minimum).The point here is that if prices cannot reach what would be theequilibrium, then a gap will emerge between the quantitydemanded and quantity supplied. In turn, a lack of equalitybetween the quantity demanded and supplied causes otherevents to occur. Although these secondary effects are indirectlyrelated to the price control, they may be of a sufficient magni-tude and therefore deserving of our attention.Let’s consider an example where a price ceiling is imposed on aspecific market. Our market will be the market for regularunleaded gasoline (87 octane) and we’ll assume that this marketcan be described by the demand and supply model in thefollowing graph (note the steep slope of demand impliessomething about how people respond to changes in the priceof regular unleaded gas):
In this setting, Q* units of regular unleaded gasoline, whichwe’ll assume is 9.5 units (we’ll assume that each unit is onehundred thousand gallons), are sold at a price of P*, whichwe’ll also assume is $1.45 per gallon.Suppose consumers lobby the government, asking for interven-tion in this market. Their claim is that the high price of regularunleaded gasoline hurts middle and lower income individualsmore than higher income drivers because rich people use carsthat require a higher octane that what’s provided in regularunleaded. Let’s assume that these people are successful and thatthe government places a price ceiling of $1 on regular unleadedgas (but no ceiling on the more premium brands). Demandersand suppliers can still agree to transact at any price they want,but only as long as that price is below the ceiling.We can illustrate this ceiling on the previous graph as follows:
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Because the price cannot legally rise above $1, demanders andsuppliers must interact at this new price (not the price thatwould otherwise be the equilibrium price). We determine howmuch suppliers would provide at this price by looking at thequantity supplied (Qs) at the $1 price. Let’s suppose that theresulting quantity supplied is 5.25 units (i.e. 525,000 gallons ofregular unleaded gasoline). Similarly, if we consider the quantitydemanded (Qd) at $1, then we observe 1 million gallons beingdemanded. Of course, demanders will not be able to get thisone million gallons, because only 525,000 gallons are beingsupplied. Therefore, the price ceiling leads to a shortage of475,000 gallons. The change in quantity demanded andsupplied, and resulting shortage, is a direct effect of the priceceiling.Note also that there are fewer gallons being exchanged in thismarket. That is, not only does the price ceiling cause a 475,000gallon shortage to occur, but there are also 425,000 fewer gallonsof regular unleaded being sold. Many of the drivers whoformerly purchased regular unleaded gas will have to turn to analternative fuel (or fuel source) because they cannot buy thegasoline they used to buy before the price ceiling.The price ceiling may also have some indirect effects on thismarket. Whereas the price ceiling may directly lead to a shortage,the shortage may (in turn) have an effect on the behavior ofdemanders and suppliers.Several outcomes are possible, but let’s consider the short runpossibilities first. We’ll define the short run as a period of timewhere demanders and suppliers face at least some adjustmentconstraints on their behavior. For instance, it’s difficult forsuppliers to just leave the market in a short time becauseexisting firms not only must first liquidate their assets, pay offcreditors, etc., but also might want to wait and see if the marketchanges after a while (e.g. perhaps the government might changeits mind about the price ceiling). Consequently, we think ofexiting the market as something firms would do in the longrun rather than the short run.Some of the possible short run adjustments might includechanges in the purchasing patterns of demanders, or sellingpatterns of suppliers. Demanders need gas because of theshortage, so perhaps they’ll turn to buying one of the moreexpensive, higher octane gasolines. If demanders cannot affordthese higher priced brands, then they may also drive further tobuy regular unleaded gas in markets where there is no shortage(or price ceiling). It’s also possible that suppliers may decide toimpose certain fees on the sale of regular unleaded. Forexample, a 25 cents per gallon “pumping charge” might beimposed on every gallon sold during busy times of the day.In the long run, suppliers might adjust by shifting towardsupplying more of these higher octane gasolines. Suppliersmight expand their ability to supply higher octane gas byincreasing their ability to store higher octane gas (and buyingsmaller storage tanks for regular unleaded gas). It is alsopossible that some gasoline suppliers will not sell gasoline anymore. Some may leave the market, some may shift over toproviding mechanic services instead. Overall, there will be adecrease in the number of suppliers of regular unleaded
gas. When the number of suppliers decreases, the supply curveshifts left and the shortage only grows.
22.7 Price Ceilings – A Welfare EconomicsOne way in which the central authority may regulate an industryis by controlling the market price. For example, one type ofprice control is a price ceiling (where the government sets anupper bound on the market price). Price ceilings set below theequilibrium price cause shortages. With a shortage, it is necessaryto determine how the product will be allocated. This handoutillustrates that the size of deadweight loss can vary with theallocation rule.Assume a that there’s a perfectly competitive market, whereconsumers buy (at most) one unit. The demand and supplycurves are:Demand: D(P) = 100 - P Supply: S(P) = 10 + .25P The equilibrium price and quantity become: P* = $80, Q* = 20.Assume that a price ceiling (Pc) is set at $40, causing a shortageof 50. What are the welfare effects of using different allocationrules? We’ll consider three.
Rule 1. Product is Allocated According to People’sWillingness to pay for itIn this regime, we allow consumers to purchase the good onthe basis of their willingness to pay. By lining consumers up,according to their willingness to pay, we have the marketdemand curve illustrated in Figure 1. Consumers with thehighest willingness to pay are allowed to purchase the goodfirst. Here, only the consumers along line segment “ab” can buythe good. Comparing the surplus achieved under competitionwith the surplus achieved under Rule 1, we see a decrease. Thisdecrease in surplus corresponds with the (lost) surplus derivedfrom consumers along line segment “bc”. Consequently,deadweight loss becomes the shaded area “bcd”.
Rule 2. Product is Allocated by the Lottery MethodIn this regime, the government allocates the good randomly bygiving consumers the right to purchase the good if their nameis selected from a lottery. Recall that each consumer buys (atmost) one unit of the good. At Pc = $40, 60 units are de-manded and only 10 supplied. Therefore, each consumer has a1/6 chance of purchasing a unit. Since only 1/6 of the D(Pc)consumers can purchase the good, our allocation rule impliesthat the resulting consumer surplus will be 1/6th of the totalarea below the demand curve and above the price of $40. InFigure 2, by adding the allocation rule [(1/6)D(P)], we can see
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this area of consumer surplus as lying below line segment “ad”and above the ceiling price.Consequently, the deadweight loss resulting from Rule 2corresponds with the shaded area “acd”. This loss arises becauseof two factors: (a) the decrease in output associated with theprice ceiling (equal to area “bcd” in Figure 1); and (b) the loss inwelfare associated with improper allocation (equal to thedifference between areas “acd” and “bcd”). Regarding thesecond factor, the allocation is improper because a limitednumber of units are allocated to consumers who place a lowervalue on the good (i.e. those consumers associated with lowerpoints on the demand curve). Those who want the good themost, in terms of how much they’re willing to pay for thegood, won’t necessarily get the good.If a black market developed and consumers were allowed toresell the good, the deadweight loss in Figure 2 would approachthe size of the deadweight loss in Figure 1. When a low valueconsumer resells the product to a higher value consumer, thelow value consumer derives “rents” from the sale. In the end, ifonly the higher value consumers hold the good (i.e. thoseconsumers along line segment “ab” in Figure 1), then theresulting deadweight loss is the same as that of the previousexample (shown by Figure 1).
Rule 3. Product is Allocated by the Good’s SuppliersWhen suppliers allocate the good, consumers compete againstone another to acquire the product. This competition may occurin a variety of ways, but we expect that the high value consum-ers will be willing to pay extra for the good - up to the differencebetween their respective reservation price and the ceiling price.There are several ways in which they may do so. One is to waitin line. In this case, consumers will consider their opportunitycost of time and how long they must wait in line to purchasethe good. If the opportunity cost of waiting in line (for eachconsumer) corresponds with lost wages of $10 per hour, andconsumer A’s reservation price is $80, then consumer A will waitin line no more than 4 hours to purchase the product. Sincetime is a real resource, giving up time to wait in line representsan additional welfare loss to society. For example, time spentwaiting in line could have been spent providing labor in theproduction of goods and services.It is also possible that consumer A might bribe the supplier, inorder to acquire the product. No bribe will be greater than thedifference between a consumer’s reservation price and ceilingprice of $40. Since monetary bribes involve exchanging apecuniary resource, there is no additional welfare loss to societyother than that associated with area bcd in Figure 1. The reasonis that a monetary bribe is simply a financial transfer fromconsumer to supplier.
Notes
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LESSON 23:PRICING STRATEGY
23.1 Pricing Strategies for theMonopolistWhen firms can set their own price, then there are a variety ofstrategies that each firm may follow. Naturally, if a firm is profitmaximizing, then the strategy chosen will be that which bringsin the most (economic) profit. Three of these approaches, linearpricing, price discrimination and the two part tariff, are dis-cussed below.1. One price for all units sold. In economics circles, this
approach is referred to as linear pricing and is the mostcommonly discussed approach in the microeconomicscourse. A firm will adjust the quantity of output it suppliesuntil finding a point where the marginal revenue associatedwith selling that quantity is equal to the marginal cost ofproducing that quantity. That is, the firm will produce whereMR = MC.
When following this approach, the firm will then charge aspecific price that applies to each unit sold. If we consider this inthe context of a monopolist choosing an output level, then wehave the graph below.
The monopolist finds where MR = MC, which occurs at pt A.Directly below pt A, we see the monopolist’s output (Q*).Going up from pt A to pt B, and then left to the Price axis, weget the monopolist’s price (P*). Profit (blue area) is the differ-ence between the price and average cost associated withsupplying Q* units of this good. AC* represents themonopolist’s average cost of supplying Q* units, which comesfrom where the dotted line (up from Q*) hits the AC curve atpt C.Just as with profits, we also see that there is some consumersurplus (orange area above the price and below demand) anddeadweight loss (yellow area to the right of Q*, betweendemand and marginal cost). The deadweight loss arises because
the firm produces an inefficient amount of output. That is, thefirm is not producing where P = MC, which is considered theefficient amount of output.Here, the firm charges one price (P*) for all units sold. If twoconsumers purchase the same item, but at a different price, thenthe difference in price corresponds with what must be thedifferent cost of supplying these two consumers. For example,if consumer A buys one unit of this good at P*, and consumerB buys one unit for P** (where P* > P**), then it must be truethat the price of B’s unit arose from a shift in the MR or MCcurve. It’s also possible that there was a transportation cost (e.g.shipping and handling) tacked onto A’s price that wasn’treflected in the graph.2. Different prices for different consumers. This approach is
referred to as price discrimination, and, unlike the firstapproach, corresponds with differences in what consumersare willing to pay, not as the result of changes in demand ordifferences in supply cost.
For example, entertainment providers often charge differentprices to students, the general public, seniors, etc., even thoughthe cost of supplying that entertainment to each consumer isidentical. Profit maximizing movie theatres, carnivals, etc.,realize that some consumers are willing to pay more, or are ableto pay more, for entertainment than other consumers. Theproblem is that demand-related consumer information is notreadily available to suppliers. Ticket booth operators at themovies could try to ask consumers about their willingness topay for tickets, but they aren’t likely to get much informationbecause consumers have no incentive to tell the truth abouttheir preferences. As a result, movie theatres must considerother variables, variables that are easily observed like age, incomeor time of purchase, which are likely to be correlated withwillingness to pay.Assume that there is only one form of entertainment in town,and that the movie theatre is a monopoly provider of thisentertainment. Once the movie theatre manager determineswhat variables are correlated with willingness to pay, themanager will charge different prices to each of the differentidentifiable groups. The result is something like what the graphillustrates below.
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Rather than charge just P1 (which corresponds with P* in theone price for all units sold approach), the theatre owner cancharge prices P2 and P3 to seniors and youth (under 18) respec-tively. Both of these prices will attract additional sales, whichwould never have occurred when the theatre charged P*. Becausethese groups can buy tickets at a price that is above AC, thetheatre can exact additional profits (given as the pink andgreenish areas to the right of the original blue profit boxcorresponding with P1).Note that the market (if this theatre is a monopolist) generatesadditional consumer surplus (orange areas above each price) anddramatically decreases the deadweight loss (still dark green, tothe right of Q3 and between demand and MC) that occurredwhen only one price was charged for all units sold. Deadweightloss became smaller because more units were sold. Therefore,this approach accomplishes three important objectives: the firmreceives additional profits, consumer surplus has increased, andthe market output is closer to what we (society) consider anefficient level of output (i.e. where P = MC for the last unitsold).Only one problem remains for price discriminating firms likethis theatre owner. If general admission consumers are able tobuy tickets at youth prices, then the whole pricing strategy couldfall apart. That is, the theatre owner could possibly becomeworse off by attempting price discrimination instead ofcharging one price for all units sold. To make price discrimina-tion successful then, the movie theatre must prevent the resaleof movie tickets between the different consumer groups. Oneway to do this might be to color-code the tickets, so that adultscouldn’t have their kids buy tickets for the whole family to getadults and kids in at youth prices.
Price Discrimination, A Numerical ExampleAssume that a local concert provider has a monopoly over theprovision of heavy metal rock concerts. The firm has estimatedthat its market demand curve can be drawn from the followingequation (where P = price and Q = quantity demanded):P = 130 – 2QMarginal revenue (MR), in this case, would be MR = 130 - 4Q.The firm’s average and marginal costs are constant, in that theAC and MC equations are both always equal to $40. Theseequations appear as follows:AC = 10MC = 10If the firm was to charge one price for every ticket it sells, thedemand, MR, MC and AC curves inform us that the firm willsell 30 tickets at a price of $70 per unit and make economicsprofits of $1800 (you may want to verify this on your own).Let’s assume that the firm has enough information on itsmarket to utilize a price discrimination pricing strategy. To be aprice discriminating monopolist, this firm must do two things:1. Separate consumers into different groups, based on
differences in their maximum willingness to pay for thefirm’s product
2. Prevent the resale of the firm’s product between thesedifferent groups
Let’s further assume then, that the firm has determined thatyounger consumers (under 50) are willing to pay up to $80 perticket for an upcoming heavy metal band concert and that olderconsumers (50 or older) are willing to pay up to $30 per ticket torock on at this concert. If the firm uses price discrimination,based on age differences, how do we measure the effects of thispricing strategy on profits?If the monopolist sets a price of $80, then we calculate thenumber sold by plugging P = 80 into the market demandequation and solving for Q.P = 130 – 2Q80 = 130 – 2QQ = 25If the firm sets a price of $30, then we can similarly calculate thenumber that would be sold at P = 30.30 = 130 – 2QQ = 50Of course, if there are two prices charged, we want to considerthe additional sales that occur because of the lower price - whichis the difference between the two quantities (25 and 50).Therefore, as the graph shows below, the $80 price will result in25 tickets being sold to the younger group whereas charging theolder consumers a price of $30 will cause the overall sales toincrease to 50 tickets (i.e. an 25 additional tickets are sold).
Profits (p) are measured as the net revenue generated from thesales of this good at the two prices given above (where the “1”subscript denotes the younger group, and the “2” subscriptcorresponds with the older group). The pink area correspondswith the profits derived from sales to group 1, and the greenarea corresponds with the profits derived from sales to group 2.p = “Pink Area” + “Green Area”p = (P1 – AC1)Q1 + (P2 – AC2)(Q2 - Q1)p = (80 – 10)25 + (30 – 10)(50 - 25)p = 2250The firm can obviously make more profits now than whatwould have been attained in the pre-price discriminationsystem.
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Note that we could have chosen a different pair of prices towork with, and that our profits from price discrimination couldgo up or down, depending on which prices we chose. Forexample, prices of $90 and $10 would yield total profits of$1600; whereas prices of $75 and $30 would yield total profitsof $2287.50.3. Set up a “club” and charge one price for all units. This
approach is referred to as the two-part tariff. Consumers firstpay a flat (fixed) fee which effectively gives them the “right”to buy as many units of a good as they want at a given price.The flat fee has many names. Sometimes it’s called amembership fee, at other times it’s a hookup fee, and insome situations the fee is called an entry fee. In each case,however, all consumers will pay the same fee regardless ofwhether they end up buying anything (thereafter) or not.Once the fee is paid and the consumer is effectively inside thestore, each consumer can purchase varying amounts ofwhatever is being sold.
This pricing strategy has many examples. The State Fair chargesan entry fee, and then specific prices for each ride. Some discountstores (e.g. Sam’s Club) ask shoppers to first pay a membershipfee, before going inside the store to purchase various productsat their discounted prices.If the individual prices of each good exceed the good’s averagecost, the firm will make profit. Additional profits can also bebrought in, however, with the fixed fee. The amount of fixedfee revenue collected depends on the available consumersurplus. As the firm sets a lower price for the units supplied,the consumer surplus becomes larger. Larger consumer surplusmakes it possible for the firm to collect more revenue by eithercharging a larger membership fee or by adding members.How might this approach work if the theatre manager decidedto use this pricing approach instead of either of the previoustwo approaches? Again, we can see this with the use of anothergraph.
The manager could charge an entry fee, something that allowsmovie-goers to enter the theatre and buy their tickets. Becauseconsumers are willing to pay an entry fee that is no greater thantheir potential consumer surplus, the movie theatre realizes thatit is possible to collect up to the amount of the aggregateconsumer surplus from this market (the dark green area abovethe price P1). The lower the price, the greater the market
consumer surplus and the higher the (potential) entry feerevenues. Therefore, we should expect the movie theatre to setlow ticket prices as an inducement to get consumers to pay theentry fee. While lower prices would not bring monopoly-likeprofits, the entry fee revenues could potentially raise profitsabove those attained by the other monopoly’s one price for allunits sold strategy.In the graph, the movie theatre sets a price that is equal tomarginal cost (to do so requires setting the price where MCcross the demand curve at pt. A). This price brings forth profitsthat are represented by the blue profit box. If the entry fee is sethigh enough, the movie theatre can add the entire greenconsumer surplus area to total profits also.Similar to the price discrimination approach, we see that thetwo-part tariff pricing strategy may lead to a big reduction indeadweight loss and concurrent increase in output. Conse-quently, we can see that the monopolist may not be asinefficient as first believed with the one price for all units soldapproach. We should concede as well, however, that consumersurplus may potentially disappear with the deadweight loss ifthe firm can successfully set prices that are equal to eachconsumer’s maximum willingness to pay (in the case of pricediscrimination) or set a fixed fee that allows the firm to secureall of each consumer’s consumer surplus.Two-Part Tariff, A Numerical ExampleSuppose the campus bookstore has a monopoly over thesupply of textbooks. The bookstore hires someone to estimatetheir (market) demand curve and receives the followinginformation (where P = price and Q = quantity demanded):P = 100 - 1.5QMarginal revenue (MR), in this case, would be MR = 100 - 3Q.The firm buys all of its books from a book publisher at $40 perbook, making the bookstore’s average and marginal cost (ACand MC, respectively) always equal to $40. The bookstore’s ACand MC equations would be:AC = 40MC = 40If the firm was to charge one price for book it sells, thedemand, MR, MC and AC curves help us in determining thatthe bookstore will sell 20 books at a price of $70 per book.Economic profits would be $600 (you may want to verify thison your own).Let’s assume that the bookstore owner hears about two-parttariffs and would like to implement this pricing strategy.Students are asked to pay a cover charge, just to enter the store,and may then buy all the textbooks they want at some pre-determined price.The lower the textbook price, the more consumers save. Morespecifically, the lower the price, the greater the consumer surplus.The bookstore knows that the two-part tariff pricing approachallows them to recover any lost profits (from lower prices) byraising the cover charge, so the firm will adjust the cover chargeand textbook price to a point where profits are as high aspossible.
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Given the demand for economics textbooks, the bookstoredecides on a price of $40 per book. That is, the bookstoredecides to sell the textbooks at cost. To determine how manybooks are sold at this price, we take the demand curve and plugthe price of $40 in for P before solving for the quantity sold(Q).P = 100 - 1.5Q40 = 100 - 1.5QQ = 40In the absence of any cover charge, this would allow consumersto obtain (overall) consumer surplus of $1200. This is illus-trated in the graph below, where the blue area representsconsumer surplus.
Because consumer surplus is the area of the triangle borderedby the demand curve, price and vertical axis, we can calculate thearea of this triangle as:CS = 0.5(“base” x “height”)CS = 0.5(Q* x [“y-intercept” - P*])CS = 0.5(40 x [100 – 40])CS = 1200Because we don’t have enough specific information about thevarious consumers making up this market, including how manyconsumers there will be, we can only make guesses at the covercharge.For example, suppose there are 30 students who think they cansave money by paying the cover charge to enter the bookstore.If the bookstore sets the cover charge at $25 per person andthere are 30 students willing to enter, then the firm can earntotal profits (i.e. profits from booksales + revenues from thecover charge) of $750.
23.2 Price Discrimination: A SummaryDiscussions of firm pricing behavior often assume that a firmwill charge the same price to all consumers. In reality, we findexamples like theatres who charge different prices to students,the general public, seniors, etc. - even though the cost ofsupplying “entertainment” to each of these consumer types isthe same. This corresponds with a practice known as pricediscrimination.What is price discrimination? The standard discussion ofprice discrimination centers on the following brief definition:“Price discrimination is the sale (or purchase) of different unitsof a good or service at price differentials not directly corre-
sponding to differences in supply cost.” (Scherer and Ross,1990)How do firms conduct price discrimination? Price discrimi-nation is founded on a firm’s ability to distinguish amongstbuyers, based on their varying demand characteristics for aparticular product. The more a firm is able to do so, the moreperfect the degree of price discrimination.Three conditions must exist to enable a firm to profitably pricediscriminate: (a) the firm must have market power, (b) the firmmust be able to distinguish among buyers on the basis of theirdemand-related characteristics (e.g. demand elasticity or reserva-tion price), and (c) the firm must be able to constrain resalebetween buyers with high and low reservation prices (ordemand elasticities).There are three degrees of price discrimination (illustrated below): (a)first degree (perfect), where firms charge each consumer theirreservation price for the good; (b) second degree, where firmscharge “blocks” of consumers their reservation price for thegood; and (c) third degree, where firms divide consumers intotwo or more submarkets, each with its own demand curve, andindependently maximize profits in each submarket.
What types of price discrimination are found in practice?There are three main classes, each with differing intra-typeexamples: personal discrimination, which is based on differencesamong individual consumers; group discrimination, whereintergroup differences are the distinguishing factor; and productdiscrimination, where different products are priced in a discrimi-nating manner.Here are some examples of each type of price discrimination(from Scherer and Ross, 1990):
Personal Discrimination
1. Haggle-every-time: each transaction is a separatelynegociated bargain. Examples: Middle Eastern bazaars, andnew/used car sales.
2. Size-up-their-income: wealthier (individual) customers areexpected to possess more inelastic demand and are chargedmore than less affluent consumers. Examples: legal andmedical services.
3. Measure-the-use: customers who use a product more arecharged a higher price that is not proportional to anydifference in costs. Example: Xerox machine rental charges.
Group Discrimination
1. Dump-the-surplus: goods in excess supply are exported atreduced prices, to prevent depressing domestic monopolyprices. Example: export market dumping (e.g. televisions,computer chips, etc.)
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2. Promote-new-customers: new customers are offered lowerprices than existing customers to develop new brand loyalty.Examples: newspapers and magazines.
3. Keep-them-loyal: special discounts are given to highvolume buyers or prized customers. Example: frequent flierprograms.
4. Sort-them-by-time-value: coupons which involve a timecommitment for redemption are given to customers. Thosewho redeem these coupons are presumed to have a loweropportunity cost of time, which corresponds with a lowerreservation price. Examples: mail-in rebates, and newspapercoupons.
5. Divide-them-by-elasticity: separating customers on thebasis of belonging to a particular group, when there is anexpectation that the demand elasticity or reservation price willvary among each group. Examples: business vs. tourist rateson travel, and student vs. general admission prices forentertainment.
Product Discrimination
1. Appeal-to-the-classes: pricing higher quality products toachieve larger markups than with lower quality products.Examples: cloth vs. paperbound books, and luxury vs. mid-size economy cars.
2. Make-them-pay-for-the-label: charging higher prices for(homogeneous) goods, based on name recognition.Examples: Name-brand vs. generic aspirin, salt, etc.
3. Clear-the-stock: clearance sale prices are charged on certainitems when inventories need to be reduced, with the hopethat these lower prices will induce purchases by customerswith tight budgets. Example: Macy’s, or other high-end storeclearance sales.
4. Switch-them-to-off-peak-times: for goods and serviceswith varying time-consumption patterns, lower prices arecharged during off-peak periods. Examples: hotel and motelrates, and long distance telephone rates.
5. Skimming: setting high introductory prices that are designedto exploit customers eager to buy a new product. Example:introductory automobile prices.
Notes
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LESSON 24:ACQUIRING AND USING MARKET POWERS
24.1 A Review of Perfect Competitionand MonopolyIt is typical in microeconomic analysis to discuss perfectcompetition and monopoly. This handout is a basic review ofthese two extreme cases of market structure, but it is alsointends to motivate the further investigation of some relatedtopics.
Perfect CompetitionWhen defining what is meant by a “competitive market” oneusually thinks of many firms, with each firm charging a lowprice. Each firm’s price will be high enough to ensure a “fairreturn” but also low enough to keep other firms from outsell-ing them.A perfectly competitive industry is characterized in the short runas one with many small firms, each selling a homogeneous(standardized) product. In the long run, a perfectly competitiveindustry has no barriers to entry or exit. That is, firms may enterand exit the industry as necessary.What do these conditions directly imply about perfectlycompetitive industries?1. Selling a homogeneous product leads to one price for all
firms.2. Many small firms implies that each firm produces for a small
segment of the overall market, so small in fact that no singlefirm can affect the market price. It is the behavior of themarket as a whole which determines the market price. Inturn, the market price serves as the demand curve for eachfirm.
3. Free entry into or exit from an industry implies that theindustry’s firms will make zero economic profits in the longrun.
What do these conditions indirectly imply about perfectlycompetitive industries?1. Since firms cannot affect the market price, their marginal
revenue will always equal the market price.2. Firms adjust their output levels in order to maximize
profits. They produce where their marginal cost (ofproducing a specific output level) equals the market price.This implies further that the firm’s marginal cost curve is itssupply curve as well.
3. Once the market price and output levels are set, we find thattotal economic surplus is at a maximum. This results fromthe fact that each firm is producing where P = MC, whichimplies allocative efficiency.
MonopolyIn the popular board game Monopoly, the object is to eliminateone’s competitors by buying up their property. That is, tobecome a monopolist. En route to this end, as a player buys up
more and more property, their “profits” rise. In both the gameand popular culture, monopolies are often characterized as highprofit firms, made rich no doubt after charging exorbitant pricesto hapless widows and children.By definition, a monopolized industry is an industry inhabitedby only one firm. In the long run, a monopolistic industry hashigh barriers to entry and exit. Entry and exit are made difficultby either natural causes (e.g. cost conditions or trade secrets) ormore artificial ones (e.g. patents or government involvement).What do these conditions directly imply about monopoly?1. With one firm meeting all of market demand, that one firm
determines its own market price.2. When firms may not freely enter or exit an industry, the
economic profits of the industry’s firms are greater than orequal to zero in the long run. The actual profit level willdepend upon the firm’s average costs.
What do these conditions indirectly imply about mo-nopoly?1. Since a monopolist can set its own price, that price will exceed
the monopolist’s marginal revenue.2. A monopolist maximizes profits by producing where her
marginal cost equals her marginal revenue.3. Since the firm’s price will be greater than its marginal cost,
total economic surplus is not at a maximum, implyingallocative inefficiency.
Further QuestionsWhile instructive in a theoretical context, these extreme casesaren’t often observed in the real world. We may then want toask some deeper, more empirically driven questions. Here aresome examples:1. Since perfectly competitive firms are unable to affect the
market price and since monopolists operate withoutcompetition, we see that there is no strategic interactionamong firms within perfect competitive or monopolymarkets.a. How would we model strategic interaction within a
market?b. What effect does strategic interaction have on prices and
output levels?2. Real firms compete in ways other than just setting a price or
output level. For example, in the short run, firms maydifferentiate their product from that sold by a competitor orfirms may compete through innovation, affecting their rateof output growth over the long run.a. How do firms differentiate their products, and how does
that product differentiation affect market outcomes?b. While some market structures may lead to allocative
inefficiency, is it possible that through innovation these
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same markets may have higher rates of innovation andachieve higher rates of output growth?
3. Our previous analysis says little about how monopoly is achieved.a. Should it matter how firms come to dominate a market?b. What happens in monopoly markets when barriers are
not so high as to prevent entry forever?
24.2 Innovation and Market StructureOne of the industries is a monopoly (industry A), the other isperfectly competitive (industry B). What is the incentive toinnovate in these two industries? Assume that the industriesface identical demand and cost curves:• Industry demand: P = 100 - Q (monopolist’s MR = 100 -
2Q)• Marginal Cost: MC = AC = $20• An inventor designs a way for each industry to lower unit
costs by $10 per unitA. Incentive to innovate = size of the inventor’s royaltySuppose that our inventor can choose between selling theinnovation to industry A or B. Whoever pays the biggest royaltygets the innovation. How much are they willing to pay? Theanswer is, no more than the change in their costs (i.e. $10 perunit). Therefore, we’ll set the royalty fee at $10 per unit. Theinnovation would lower MC in both markets (to MC2), but theroyalty fee would bring MC back to its pre-innovation level (to
MC1).
The inventor would collect a larger royalty from the competitiveindustry than the monopoly. The monopolist would pay $400,and the competitive industry would pay $800. This higherroyalty from the competitive industry has been interpreted toimply a greater incentive to innovate with perfect competitionthan with monopoly.Some researchers argue that it is misleading to define theincentive to innovate as the size of the royalty paid to theinventor because this approach is biased against monopolies.Another way to define the incentive to innovate is in terms ofthat innovation’s effect on industry profits.B. Incentive to innovate = change in industry profitsInstead of assuming that an inventor can sell this innovation tothe highest bidder, assume that the royalty paid is the samebetween industries A and B. To do this, assume that industriesA and B the same marginal revenue and cost curves (rather thanthe same demand and cost curves as we did above).
Suppose there’s a two-step process to this example: (a) industryand inventor get together and decide the amount of the royalty,and (b) given the royalty, the industry determines how much toproduce. Set the royalty at $400 again. Taking this $400 paymentas given allows each industry to operate along a new, lower MCcurve. In both industries, output rises from 40 to 45.What happens to profits in industry B? In the competitiveindustry, price falls to marginal and average cost - implying zero(gross) profits for the industry, both before and after theinnovation is introduced. Taking the $400 royalty out of thisamount means a $400 loss. Consequently, the net change inprofits is -$400.What happens to profits in industry A? The monopolist’s pre-innovation profits are $1600. After the innovation, MC declines.Output rises to 45 units and the price falls to $55. Themonopolist’s post-innovation (gross) profits become $2025.After paying the royalty, the monopolist’s net change in profitsis $25. This implies a stronger incentive to conduct innovationin monopoly than in perfect competition.
24.3 The Measurement of Market PowerTwo firms produce a homogeneous product at constant costsand maximize their profits by optimally setting their outputlevels. There is some degree of strategic interaction betweenthese firms, measureable to some extent by looking at theability of each firm to mark up its price over marginal cost. Thefirms face the same market demand curve (where q1 + q2
represents the market’s total output):P = 100 - (q1 + q2)Firm 1 maximizes its profits by setting its own marginalrevenue equal to its marginal cost. Their marginal revenuewould be: MR = 100 - 2q1- q2. Rather than complete thisexercise, however, let’s consider what happens if we rearrangefirm 1’s MR a little (firm 2’s MR would be the same as firm 1’sexcept that we would have to swap the subscripts on the q’s).Another way of writing firm 1’s MR is: P - q1(1 + a1)The most important term in this expression is the “a” term.This term measures the change is called the conjectural variationof firm 1, and it reflects the degree of interdependence men-tioned above. More technically, it is a measure of how changesin firm 1’s output affect firm 2’s output choice: Dq2/Dq1. Wecan assume that Dq2/Dq1 = Dq1/Dq2, which means that both
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firms hold the same conjectural variation (allowing us to dropthe subscript on this term).Now, let’s look again at firm 1’s profit maximization process.Set MR = MC:P - q1(1 + a) = MCwhich can be rearranged as follows:P - MC = q1(1 + a)Divide both sides by P, and multiply the righthand side (RHS)by Q/Q. The result is:
When all the firms in the industry have the same MC, theyproduce the same level of output (in this example, each firm’sMC is constant at the same amount). That being the case here,we can re-express the q1/Q term as 1/n (where n = the numberof firms, which in this example is 2):
On the lefthand side of the equation, we have firm 1’s price-costmargin (PCM). Another name given to this expression is theLerner index. As the price elevates above marginal cost, the firmmakes steadily higher profits. On the RHS are three reasons forvariations in firm 1’s PCM: (a) changes in firm 1’s market share(q1/Q or 1/2); (b) changes in the market’s elasticity of demand(ed), or (c) changes in the firm’s conjectural variation.
From this Last Equation, three Interesting CasesEmerge
Case 1: a = -1. If firm 1 increases their output, and firm 2decreases their output by the same amount, we have Bertrandcompetition. This condition implies that changes in eitherfirm’s output do not affect the market price, which also occursin perfectly competitive markets. These firms have no marketpower and their PCM is zero.Case 2: a = 0. If firm 1 increases their output, and firm 2 ispassive - which means that they make no changes in theiroutput level - there is Cournot competition. In this setting pricewill exceed marginal cost, which signals the presence of somemarket power.Case 3: a = 1. If firm 1 increases their output, and firm 2increases their output by the same amount as firm 1, as thoughthe firms were acting in unison, then we have perfect collusion.The PCM reaches its greatest level as the firms act as thoughthey were a single firm. Perfect collusion may be explicit, by theforming of a cartel, or implicit, as firms collude tacitly throughobservation and reaction. A more general way of stating thiscase is by saying that it occurs when a = n - 1.
24.4 Vertical Product DifferentiationLet’s begin by assuming the following:
•· 2 firms, each produces a differentiated good at zero cost.Firm 1 produces good H, and firm 2 produces good L.
• Firm 1 has a higher quality product than firm 2. If ki (where i= H or L) represents quality, then this assumption impliesthat: kH > kL > 0
• 100 consumers with identical incomes, E, but differenttastes, qi (i = 1,...,100), that are uniformly distributedbetween zero and one hundred.
• Each consumer must decide whether to buy (at most) oneunit from firm 1, one unit from firm 2, or buy nothing.
Utility functions determine what each consumer does:
• if consumer x buys nothing: Ux(0,E) = E• if consumer x buys good H: Ux(kH,E) = (E - p H) + qxkH
• if consumer x buys good L: Ux(kL,E) = (E - p L) + qxkL
1. There is one consumer who is indifferent between buyingnothing and buying the lower quality product of firm 2.This person is identified by their taste parameter, qz. Theirutility from buying nothing is equal to their utility frombuying good L:
E = (E -pL) + qzkL
”Solving this equation for qz, gives us the “location” of thisconsumer:
2. There is another consumer who is indifferent between buyinggood L and good H. This person is identified by their tasteparameter: qw.Their utility from buying good L is equal to their utility frombuying good H:(E -pL) + qwkL = (E -pH) + qwkH
”Solving this equation for qw, we get the “location” of thisconsumer also:
”Think about these consumers as standing in a line, from thelowest q to the highest. By including the position of our two“indifferent consumers”, we can get an idea of the “marketshare” for these goods.
From that information, we can get these demand functions(since the line above measures market share, we have tomultiply by the number of consumers to get the demands):
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S-INotice that if pH = pL, everybody buys good H and nobody
buys good L. That verifies we are working with a model ofvertical differentiation.
Profit MaximizationEach firm maximizes its profits (interdependently). That meanseach firm must equate their own MR with MC (remember thatMC is zero), and then we solve “simultaneously” for theirdifferent prices or output levels (here it’s prices).Below, we walk through the profit maximization process, to thestage where we obtain the equilibrium prices and output levelsfor firms 1 and 2, as well as their equilibrium profits.
What should we notice about these results?
• Firm 1 charges a higher price than firm 2.• Even though this is Bertrand competition, both firms have
P > MC(as long as kH > kL > 0).
• Firm 1 always has a profit-incentive to increase the quality oftheir good, firm 2 does not have that same incentive. Forfirm 2, an increase in quality is bad for profits when thedegree of differentiation is small (if 8kH
2 - 15kHkL + kL2 < 0,
then pL falls with an increase in kL).
24.5 Horizontal Product DifferentiationWe begin by assuming:
• 2 firms, each sells the same good at zero cost but fromdifferent locations along Main Street. Firm 1 sells good 1,and firm 2 sells good 2.
• · Main Street is a mile long (from one end of town tothe other). Firm 1 sells good 1 at their shop, located 1/6 of amile from where Main Street begins, and firm 2 sells good 2
at their shop, located 1/6 of a mile from where Main Streetends.
• Consumers are uniformly distributed along Main Street,with their location being determined by where they live.Consumers incur a cost in walking to either shop. That costequals (t x c), where t = distance travelled and c = cost perunit of distance.
• Consumers may buy (at most) one unit from firm 1 or oneunit from firm 2.
Somewhere along Main Street is a consumer who is indifferentbetween walking to firm 1’s shop or firm 2’s shop. This personis identified by their address, which we’ll call z. We don’t knowwhere z is actually located (hence the question mark below), butonce we do it’s possible to know who buys from which firm.Here’s what this would look like visually.
If this consumer is indifferent between buying good 1 andgood 2, then it’s because they’d pay the same price for eithergood. Including the cost of walking to a particular firm, theeffective price is p + (t x c). We can figure out the value of t bycalculating the distance between z and each firm.• The distance between z and firm 1 is (z - 1/6)• The distance between z and firm 2 is (5/6 - z)Let’s substitute these values in for t, and set the effective pricesof each firm’s good equal to one another: p 1 + (z - 1/6)c = p 2 +(5/6 - z)cSolving this equation for z, we get the location of the indiffer-ent consumer:
Everybody between z and the beginning of town will shopwith firm 1, and everybody at the other end of town will shopwith firm 2. Therefore, their demands correspond with thefollowing (under the added assumption thatp2 - c < p1 < p2 + c):
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Profit MaximizationEach firm maximizes its profits (interdependently). That meanseach firm must equate their own MR with MC (remember thatMC is zero), and then we solve “simultaneously” for theirdifferent prices or output levels (here it’s prices).Below, we walk through the profit maximization process, to thestage where we obtain the equilibrium prices and output levelsfor firms 1 and 2, as well as their equilibrium profits.
What should we notice about these results?
1. Firms 1 and 2 charge the same price (since the goods arehomogeneous).
2. Even though this is Bertrand competition, both firms haveP > MC(as long as c > 0).
3. Both firms have an incentive to change locations. Forexample, if either firm moved to a point that is 1/2 milefrom the beginning of town (i.e. the same location as z),after reworking the equations above we’d find that that firm’sprofits would increase from c/2 to 50c/81.
24.6 Collusion and Competition within a 2 firmindustrySuppose a market exists where there are only two firms.Assume that the firms (called A and B) are symmetric, whichmeans that they have identical costs. Assume also that theyproduce a homogeneous (identical) product. The marketdemand and firm A and B’s costs are:Market Demand: P = 100 - qA - qB (P = market price, q =output)There are two possibilities: (1) they maximize their own profits,or (2) they maximize their collective (joint) profits. We’llconsider both.1. If each firm maximizes its own profits.This is saying that the firms are engaged in (typical) competitivebehavior. To maximize their own profits, the firms mustproduce where their own marginal revenue is equal to theirmarginal cost. Each firm’s MR and MC are:Firm A’s MR MRA = 100 - 2qA - qB Firm B’s MR MRB = 100 - qA - 2qB
Firm A’s MC and AC MCA = ACA = 20 Firm B’s MC and AC MCB = ACB = 20 A. Find equilibrium output for each firm.
Firm A Firm B
1. Set MR = MC 100 - 2qA - qB = 20
100 - qA - 2qB = 20
2. Solve for (own) q qA = 40 - 0.5qB qB = 40 - 0.5qA
3. Plug qA equation into qB equation
qB = 40 - 0.5(40 - 0.5qB)
4. Solve for qB* qB* = 80/3 5. Plug qB* into qA equation
qA = 40 - 0.5(80/3)
6. Solve for qA* qA* = 80/3
B. Find the equilibrium market price.
1. Plug qA* and qB* into the market demand equation P = 100- (80/3) - (80/3)
2. Solve for P* P* = $140/3
”C. Find each firm’s equilibrium profits.
Firm A Firm B 1. Find (P - AC)q* for each firm
((140/3) - 20)(80/3) ((140/3) - 20)(80/3)
2. Calculate profits A* = $711.11 B* = $711.11
2. If the two firms maximize their collective profits.This is says that the firms are colluding and may have formed acartel. It is as though the firms merged into a single firm(forming a monopoly). The cartel sets the (market) marginalrevenue equal to their marginal cost. The cartel’s MR and MCare:Cartel’s MR MRC = 100 - 2Q Cartel’s MC and AC MCC = ACC = 20 A. Find equilibrium output and price for the cartel.
Firm A Firm B
1. Find each firm's output share
qA* = 40/2 = 20
qB* = 40/2 = 20
1. Find (P - AC)q* for each firm
(60 - 20)20 (60 - 20)20
2. Calculate profits πA* = $800 πB* = $800
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Summary: the firms each produce 20 units, charge a commonprice of $40 and make $800 in profits. With a lack of competi-tion, we see prices rising and output falling.If the firms operate independently, maximizing their ownprofits, they make profits of $711.11. However, if they collude,then they can make profits of $800. Direct collusion is illegal inthe United States, but even if it were not there are reasons whymany cartels would not remain intact for long.
3. Collusion and the incentive to cheatWhen firms form an agreement to fix prices (i.e. collude) thereis always some incentive to cheat on the agreement. To under-stand why, consider the following.Suppose firm A decides to increase their output slightly, to 80/3units (i.e. the amount they would produce if maximizing theirown profits). This would have no effect on their own AC, butwould change the market price. Firm A would produce 80/3units while B would continue producing their share of the carteloutput, so the price would be: P = 100 - (80/3) - 20 = 160/3.Profits for firm A become: pA* = ((160/3) - 20)(80/3) =$888.89While firm B’s profits are: pB* = ((160/3) - 20)(20) = $666.67Firm A obviously benefits, at firm B’s expense, from cheatingon the collusive agreement. Of course, once firm B realizes thatfirm A is doing this, then firm B should increase their outputtoo. The result is that the cartel falls apart and both firms endup producing their original (competitive) output levels. Thisproblem illustrates a classic conflict between maximizing one’sown welfare - in this case, profits - vs. that of the group.24.7 Strategic Entry Barriers : The Dominant Firm and LimitPricingIn some highly concentrated industries, a single (“dominant”)firm serves a majority of the market and a group of smaller(“fringe”) firms supply the rest. Martin (1994) summarizes thedifference between a monopolist and a dominant firm asfollows:“A dominant firm differs from a monopolist in one importantrespect. The only constraint on the monopolist’s behavior is themarket demand curve: if the monopolist raises price, somecustomers will leave the market. Like the monopolist, thedominant firm is large enough to recognize that a price increasewill drive some customers from the market. But the dominantfirm faces a problem that the monopolist does not: thepossibility that a price increase will induce some customers tobegin to buy from firms in the fringe of small competitors.That dominant firm, in other words, must take into accountthe reaction of its fringe competitors.”To best understand how the dominant firm may attempt toprevent entry by strategically setting its price, we need toexamine how the dominant firm and its competitive fringedetermine output. In the graph (below), we derive the residualdemand curve - facing the dominant firm (Dd) - from the MC,or supply curve, of the fringe (MCf) and market demand (Dmkt).That is, we find the “new” demand curve faced by the domi-nant firm when the market is shared with a competitive fringe.
As a monopolist, the dominant firm would charge pm andproduce qm.
With entry by the fringe, the dominant firm now faces a residualdemand curve, rather than the market demand curve. Noticethat if the market price falls below the point where the residualdemand curve, Dd, crosses the market demand curve, Dmkt, thedominant firm is (once again) a monopolist. This pointcorresponds with where MCf crosses the vertical axis (where thefringe produces zero output).Since the dominant firm chooses to produce where currentprofits are maximized (i.e. where MRd = MCd) the price falls top* and output responds by rising to q*. The competitive fringeinduces the dominant firm to exercise some restraint in pricesetting. As long as this restraint is present, the market price willremain lower. At the price p*, consumers will be willing to buymore than q* units and so we find the fringe producing as well.The fringe firm(s) will produce at qf (where p* = MCf).As the dominant firm confronts the entry of the fringe, what isthe proper course of action? One answer concerns the strategicuse of pricing. There are several approaches: static limit pricingand dynamic limit pricing. Let’s examine these individually.Static Limit pricing. One option is that the firm sets a pricethat prevents the fringe from entering the market (i.e. causes qf
= 0). The dominant firm could do this by lowering the price -from pm to MCd - causing the dominant firm’s economic profitsto fall to zero. One problem with static limit pricing concernswhether a rational firm would ever engage in non-profitmaximizing behavior. That is, the firm could make higher(current) profits by setting a different price. Naturally, thedominant firm is concerned with future profits as well, and sothe answer depends upon both current and future profits.Dynamic Limit pricing. Another option is one where the firmconsiders what is called the present discounted value of thestream of profits it receives over time. There are two ways ofviewing this approach. Each way concerns how the firm is ableto “gaze into the future.” Suppose the firm has myopic
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foresight, and can only view each period as it occurs. In thisevent, they will take entry as given and maximize current profits.In the graph above, this leads to the price p*. As entry contin-ues to expand the size of the fringe, the fringe “supply” curvebecomes flatter. A flatter fringe supply curve causes a flatterresidual demand curve for the dominant firm. Thus, thedominant firm’s price will fall as the fringe expands.If the dominant firm has perfect foresight, then they willmaximize the present discounted value of profits. Likewise, thefirm takes entry as given and allows the fringe to expand overtime. Essentially, the difference is that the myopic foresight pricewill exceed the perfect foresight price. In both cases, however,the price falls over each successive period until reaching the limitprice (here, note that the limit price is MCd - the perfectlycompetitive price).Either way, whether there is perfect or myopic foresight, thedominant firm reacts passively to the expansion of the fringe.The dominant firm seeks only to maximize their profits insome sense (either the present discounted value or current valueper period). As a result, this model becomes a way of predictingmovements in price and market share for industries like theauto or steel industry where a dominant firm or set of firmsface competition from smaller entrants.
Notes
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LESSON 25:NATURAL MONOPOLY
25.1 Natural Monopolies and PricingPolicyAssume that a certain natural monopolist has the followingdemand and cost related curves:Demand: P = 100 - Q Marginal Revenue: MR = 100 - 2Q Average Cost: AC = 15 + (400/Q) Marginal Cost: MC = 15
Why is this a Natural Monopoly?The answer stems from the monopolist’s natural (cost-related)barriers to entry. The relative position of the AC and MC curvesgive the natural monopolist a cost advantage over its competi-tion. Taking a closer look at these equations, you’ll see that ACis always going to be greater than MC. Remembering therelationship between marginal and average values, AC will bedeclining as long as MC is below it. In general then, for a naturalmonopoly, AC is said to decrease (as Q increases) through“some relevant range of market output”.
On a graph, it looks like this:
We’ll calculate the values for P* and Q* below, and also explain themeaning of the shaded areas.If allowed to decide herself, how much will this naturalmonopolist produce, and at what price?If allowed to set her own output and price, this naturalmonopolist will produce where MR = MC:Set MR = MC, and solve for Q*100 - 2Q = 15Q* = 42.5Find price by plugging Q* into the demand equation:P = 100 - (42.5) = 57.5
Therefore: Q* = 42.5 and P* = $57.50Suppose we also want to find the monopolist’s profits. To dothat, we use the formula (P - AC)Q. Before plugging thingsinto this equation though, we must find AC. The value for ACis found by plugging Q* into the AC equation to get AC =$24.41 (i.e. AC = 15 + 400/42.5).Profits are then calculated as:p = [$57.50 - $24.41]42.5 = $1406.33To make these kind of profits (the area represented on thegraph by the striped rectangle), the monopolist sets a priceexceeding what might occur within a more competitive market.This high price makes consumer surplus (shaded yellow in thegraph) rather small.One big problem with this result is that since the naturalmonopolist produces less output than what is possible underperfect competition, there is some deadweight loss (shaded blueon the graph) — which represents the value of output notproduced as a result of P > MC.To get rid of the DWL, a government regulator might step inand force the monopolist to set its price at marginal cost.
1. Marginal Cost PricingWhen the regulating agency forces this firm to set its price atmarginal cost, we have what is called marginal cost pricing. Inthis case, that means setting P = $15.How much will the firm produce when P = MC?Set Demand, or P, equal to MC and solve for Q*100 - Q = 15Q* = 85What are the firm’s profits when P = MC?If P* = $15 and Q* = 85, then AC = $19.71Profits become:p = [$15.00 - $19.71]85 = -$400.35which represents a loss. On the graph below, these values andthe areas for consumer surplus and profits are illustrated. Noticethat the area of consumer surplus overlaps that correspondingwith profit (loss), and that there is no deadweight loss since P =MC.
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Since the firm is making a loss, it needs to consider the future.That is, should the monopolist stay in this industry if, over thelong run, the best it can ever do each year is make some type ofloss? The answer would obviously be no, and so if the pricewere set at $15, the firm would eventually exit the industry.The whole point of government involvement here relates tothe fact that regulators wanted to make things more efficient (interms of allocative efficiency). However, achieving this particulartype of efficiency causes the firm to eventually exit the industry— leaving consumers with nothing. Therefore, to prevent thefirm from leaving, our regulator must also allow the monopo-list to cover her losses. One way to do this is by subsidizing themonopolist the amount of her loss ($400.35). Another way isto give up on the idea of producing where P = MC.
2. Average Cost PricingOne possibility is that the government regulator might want toallow the firm to charge a slightly higher price, but make zeroeconomic profit. This is accomplished when P = AC, anapproach that is called Average Cost pricing.Figuring out (algebraically) what the price will be is a bit moreinvolved than what we did above. To algebraically find the pricethat would equal average cost, we first set Demand (Price) equalto Average Cost (AC), then solve for Q* and lastly plug Q* intothe Demand equation to get P*:Set P = AC:100 - Q = (400/Q) + 15Rearrange this equation to get:Q2 - 85Q + 400 = 0Using the quadratic formula, we can solve for Q:Q* = 80Plugging Q* into the Demand equation, we can solve for P*P* = 100 - (80) = $20Consequently, setting P = AC means setting P* = $20, andgetting 80 units of output. In the graph below, these values aregiven, as are the corresponding shaded areas for consumersurplus and deadweight loss (remember that profits are zerohere since P = AC, but there will be some deadweight loss sinceP > MC).
Of course, the problem here is that while the natural monopo-list is able to make zero profits, thereby ensuring that the firmwill stay in business, some deadweight loss reoccurs — the verything that government involvement was trying to eliminate.
Another potential problem with government imposing thistype of (average cost) pricing is that it may create an incentive forthe firm to inflate its fixed costs. This is called overcapitaliza-tion, because the firm may overinvest in capital equipment sinceit is, in a sense, guaranteed a “normal return”.What we find is that, when charging a single price to allconsumers, a natural monopolist’s costs force us to choosebetween allocative efficiency and allowing the firm a fair returnon its investment (without subsidizing it). A final approachinvolves using two different “prices”, what we’ll call here a twopart tariff.
3. Two-part TariffSuppose the regulator forces our monopolist to sell every unitof output at $15 (i.e. P = MC), but also allows her to charge afixed (flat) fee that all consumers must pay before buying thisproduct at $15.In other words, the natural monopoly is allowed to chargesomething we could call an admittance fee. This fee establisheswho is in the market. Those consumers who pay the fee aresubsequently allowed to buy as much product as they want at$15 per unit (the MC price).Before this extra fee, a price of $15 caused the monopolist tolose $400 in profits. But with it, the fixed fee allows themonopolist to recoup those losses (by setting the fixed fee =400/N, where N is the number of consumers who want topurchase the firm’s product).For example, if there are 50 consumers who want to buy thisnatural monopolist’s product, then the firm should be allowedto charge a flat fee of $8. Doing so, allows the firm to produce85 units of output and make zero economic profit. This meansthat the government regulators get what they want — nodeadweight loss — and the firm gets what she wants — a fairreturn on her investment (which is what we interpret zeroeconomic profit to imply).
25.2 Multiple Products and NaturalMonopolyWith a single product natural monopoly, having economies ofscale implies having a natural monopoly. Is this true with amulti-product monopoly as well? Consider the followingexample.Suppose that Firm A produces two different goods: products 1and 2. If the firm decides to produce both products at the sametime, then its cost function looks like this:C(q1,q2) = q1 + q2 + (q1q2)1/3
Another option is to produce both products separately (e.g.Firm A could break down into two smaller firms, each specializ-ing in the production of product 1 or 2). If the firm producedthe products separately, specializing in the production ofproduct 1, then its cost function becomes:C(q1) = q1
On the other hand, if Firm A produced only product 2, then itscost function would be:C(q2) = q2
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1. Does the Firm have Economies of Scale?
If the firm can double its output without doubling its costs,then it has economies of scale.a. If the firm produces 8 units of each product, its costs would
be $20b. If the firm’s costs doubled, they would be $40c. If the firm doubled each product’s output, its costs would
be $38.35Firm A has economies of scale since it can double its output withoutdoubling its costs.
2. Does the Firm have Economies of Scope?If Firm A can produce both products (simultaneously) moreinexpensively than it could as two separate companies (whereeach company produces one product, rather than both), thenthe firm has economies of scope.a. If the firm produces 8 units of each product, its costs would
be $20b. If the firm produced only 8 units of product 1 (or product
2), its costs would be $8 (the total cost for the two smallercompanies would be $16)
Firm A does not have economies of scope, because the total cost ofproducing products 1 and 2 separately ($16) is less than the total costof producing them jointly ($20).Conclusion: when a monopolist produces only one product,then having economies of scale implies having a naturalmonopoly. When a monopolist produces more than oneproduct, then having economies of scale is not enough toimply having a natural monopoly. It takes both economies ofscale and scope in this case. In more technical terms, themeaning of additivity is expanded to include “scope” when themonopoly produces multiple products.
Notes
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LESSON 26:PROFIT MAXIMIZATION AND THE PERFECTLY COMPETITIVE FIRM
Our first look at firm behavior comes within the context ofperfect competition. What comes below is a step by stepexplanation of how perfectly competitive firms maximize theirprofits, both algebraically and graphically, and a discussion ofour result.Remember that, in perfectly competitive markets, no individualfirm has any influence over the market price (since there aremany firms and each is a small player in the overall market).Since each firm’s product is identical to that of other firms (i.e.products are homogeneous), all firms face the same price.While firms cannot individually influence the market pricethrough their actions, they can collectively. Therefore, ourstarting point will be the market demand and supply curves.These are the same demand and supply curves from the earliermaterial on Consumer Theory (i.e. they do all the same tricks,like demand shifting when there’s a change in income, thatthose other demand and supply curves did).(Market Demand) P = 100 - .078Qd (Market Supply) P = .02Qs + 2 Solving for equilibrium price and quantity, we get: P*= $22 andQ*= 1000 units. These values represent the price that each firmwill charge and the total number of units that will be producedoverall.A typical firm within this market has the following costs:(Total Costs) TC = q2 + 2q + 100 (Average Costs) AC = q + 2 + (100/q) (Marginal Costs) MC = 2q + 2 Let’s note a few things about the first two equations beforeproceeding. In the TC equation, q2 + 2q represents the firm’svariable costs and 100 represents the fixed costs. The ACequation is obtained by dividing the TC equation by q. Thismeans that, in the AC equation, q + 2 are the average variablecosts and 100/q are the average fixed costs.
1. Given these costs, how much should the FirmProduce?
The firm will always produce where the MC of a certain level ofoutput equals the market price. That is, the firm will adjust itsoutput level until P = MC. To find this output level, we set theMC equation equal to the equilibrium price:P* = MC22 = 2q + 2q = 10The firm will maximize its profits by producing 10 units. It ispossible to characterize this firm and market level informationwith the following pair of demand and supply graphs. Thegraph on the right represents the market, while the graph on theleft represents the firm.
The equilibrium price corresponds with where the marketdemand (DM) intersects the market supply (S). The firm acceptsthis price and decides how much to produce. This occurs wherethe firm’s marginal cost curve (MC) crosses the firm’s demandcurve (Df). Note that the firm’s demand curve is a horizontalline at the equilibrium price of $22.Another way to see whether the firm is maximizing profits is toassume that our P = MC rule isn’t true. Suppose that the firmdecides to test this rule by varying its output. If profits declineas we move away from where q = 10 (e.g. as we move between 8and 12 units), then profits must be maximized in the rowwhere P = MC.
P q MC AC Profits22 8 18 22.5 - 4.022 9 20 22.1 - 0.922 10 22 22 022 11 24 22.1 - 1.122 12 26 22.3 - 3.6
As the table makes clear, profits reach their highest level whenthe firm produces 10 units. Although it is true that the priceequals both marginal and average cost in this row, this is onlycoincidence right now (in the short run). Profit maximizationonly necessitates that P = MC.
2. How do we Calculate the firm’s Profits?
To find the firm’s profits, we take one of two approaches(where TR = total revenue, which is (P x q)):TR - TC approach P - AC approachProfit = TR - TC Profit = (P - AC)qProfit = (22 x 10) -[(10)2 + 2(10) + 100] Profit = (22 - [(10) + 2 + (100/
(10)]) x (10)Profit = 220 - 220 Profit = (0) x 10Profit = 0 Profit = 0The result is that this firm produces 10 units and makes zeroeconomic profit. Graphically, we find this result by comparing Pand AC. Recall that P comes from the action of the market (as awhole), and it is represented by the horizontal demand curveDf. AC is found by: (a) locating the firm’s output level, (b)tracing a dotted line from this output level to the AC curve, and(c) from the point where the dotted line hits AC - go left, overto the vertical axis.
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In the graph above, both P and AC are the same. We find TRby multiplying P and q, and TC by multiplying AC and q. Bythis method, the firm’s TR and TC are represented by the sameshaded area on the graph.
3. Why Would the Firm Produce if it makes Zero Profit?One way to answer this question is by seeing what happens ifthe firm shuts down. Then we’ll compare the profits (or losses)under the two situations: producing vs. shut down. Recall thatthe firm has fixed costs of $100. Assume that these fixed costsare all sunk (i.e. non-recoverable). If so, shutting down will costthe firm its $100 in sunk costs. This is worse than making zeroprofits, so the firm will produce.Supposing that the fixed costs are all recoverable, then the firmwould be indifferent between producing and shutting downsince both situations would involve making zero profit. In a lotof introductory economic analysis, however, fixed costs areimplicitly assumed to be 100% sunk.The important thing to remember here is that these profits areeconomic profits, not accounting profits. To see why this isimportant, consider how economic profits and accountingprofits are calculated:Economic profit = Actual revenue - (Actual costs + Opportu-nity costs)Accounting profit = Actual revenue - Actual costsWhile zero accounting profit would be undesirable, zeroeconomic profit is not. A person could work all day to make $1in accounting profits and be very unhappy since that personcould probably do better in some other money-making activity(i.e. the next best alternative occupation). By including opportu-nity cost, economic profit accounts for things like the value ofone’s time in producing a good or service.
Production
Central to our analysis is production, the process by which inputs are combined, transformed, and turned into outputs.
What Is A Firm?
• A firm is an organization that comes into being when a person or a group of people decides to produce a good or service to meet a perceived demand. Most firms exist to make a profit.
• Production is not limited to firms.
• Many important differences exist between firms.
Perfect Competition
• many firms, each small relative to the industry,
• producing virtually identical products and
• in which no firm is large enough to have any control over prices.
• In perfectly competitive industries, new competitors can freely enter and exit the market.
Perfect competition is an industry structure in which there are:
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Homogeneous Products
• Homogeneous products are undifferentiated products; products that are identical to, or indistinguishable from, one another.
• In a perfectly competitive market, individual firms are price -takers. Firms have no control over price; price is determined by the interaction of market supply and demand.
Demand Facing a Single Firmin a Perfectly Competitive Market
• The perfectly competitive firm faces a perfectly elastic demand curve for its product.
• The three decisions that all firms must make include:
Which production technology
to use
2 .How much
output to supply
1.
The Behavior ofProfit-Maximizing Firms
How much of each input to demand
3.
Profits and Economic Costs
• Profit (economic profit) is the difference between total revenue and total economic cost.
)( q x P
cost economic total revenue totalprofit economic ??
• Total revenue is the amount received from the sale of the product:
Profits and Economic Costs
• Total cost (total economic cost)is the total of
1. Out of pocket costs,
2. Normal rate of return on capital, and
3. Opportunity cost of each factor of production.
Profits and Economic Costs
• The rate of return, often referred to as the yield of the investment, is the annual flow of net income generated by an investment expressed as a percentage of the total investment.
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Profits and Economic Costs
• The normal rate of return is a rate of return on capital that is just sufficient to keep owners and investors satisfied.
• For relatively risk - free firms, the normal rate of return be nearly the same as the interest rate on risk -free government bonds.
Profits and Economic Costs
• Out- of-pocket costs are sometimes referred to as explicit costs or accounting costs.
• Economic costs, often referred to as implicit cots, include the full opportunity cost of every input.
Calculating Total Revenue, Total Cost, and Profit
? $ 1,000aProfit = total revenue ? total cost
$15,000Belts from supplier
14,000Labor Cos t
2,000Normal return/opportunity cost of capital ($20,000 x .10)
$31,000
$30,000
$20,000.10 or 10%
aThere is a loss of $1,000.
Total Cost
Costs
Total Revenue (3,000 belts x $10 each)
Initial Investment:Market Interest Rate Available:
Short -Run Versus Long-Run Decisions
• The short run is a period of time for which two conditions hold:
1. The firm is operating under a fixed scale (or fixed factor) of production, and
2. Firms can neither enter nor exit the industry.
Short -Run Versus Long-Run Decisions
• The long run is a period of time for which there are no fixed factors of production. Firms can increase or decrease scale of operation, and new firms can enter and existing firms can exit the industry.
The Bases of Decisions
• The fundamental things to know with the objective of maximizing profit are:
The prices of inputs
3.
The techniques of production
that are available
2 .
The market price of
the output
1.
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Determining the Optimal Method of Production
Determine total cost and optimal method of production
=Total profit
Total revenue? Total cost with optimal method
Determines total revenue
Input pricesProduction techniquesPrice of output
• The optimal method of productionis the method that minimizes cost.
The Production Process
• Production technology refers to the quantitative relationship between inputs and outputs.
• A labor -intensive technologyrelies heavily on human labor instead of capital.
• A capital -intensive technologyrelies heavily on capital instead of human labor.
The Production Function
• The production function or total product function is a numerical or mathematical expression of a relationship between inputs and outputs. It shows units of total product as a function of units of inputs.
Marginal Product
• Marginal product is the additional output that can be produced by adding one more unit of a specific input, ceteris paribus .
marginal p roduct of labor = change in total product
change in units of l abor used
The Law ofDiminishing Marginal Returns
• The law of diminishing marginal returns states that:
When additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines.
Average Product
average pr oduct of labor = total prod uct
total units of labor
• Average product is the average amount produced by each unit of a variable factor of production.
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Production Function for Sandwiches
7.00426
8.42425
10.05404
11.710353
(4)
AVERAGE PRODUCT
OF LABOR
(2)
TOTAL PRODUCT (SANDWICHES
PER HOUR)
(3)
MARGINAL PRODUCT OF
LABOR
Production Function
12.515252
10.010101
??00
(1)LABOR UNITS (EMPLOYEES)
0
51 0
1 5
2 0
2 5
3 0
3 5
4 0
4 5
0 1 2 3 4 5 6 7
Number of employees
Tota
l pro
duct
0
5
10
15
0 1 2 3 4 5 6 7Number of employees
Mar
gina
l Pro
duct
Total, Average, and Marginal Product
• Marginal product is the slope of the total product function.
• At point C, total product is maximum, the slope of the total product function is zero, and marginal product intersects the horizontal axis.
• At point A, the slope of the total product function is highest; thus, marginal product is highest.
Total, Average, and Marginal Product
• When average product is maximum, average product and marginal product are equal.
• Then, average product falls to the left and right of point B.
Total, Average, and Marginal Product
Remember that:
• As long as marginal product rises, average product rises.
• When average product is maximum, marginal product equals average product.
• When average product falls, marginal product is less than average product.
Production Functions with Two Variable Factors of Production
• In many production processes, inputs work together and are viewed as complementary.• For example, increases in capital usage lead to
increases in the productivity of labor.
210E36D
UNITS OF CAPITAL (K)
UNITS OF LABOR (L)
Inputs Required to Produce 100 Diapers Using Alternative Technologies
44C63B
102A
TECHNOLOGY
• Given the technologies available, the cos t-minimizing choice depends on input prices.
Production Functions with Two Variable Factors of Production
20
21
24
33
$52
(5) COST WHEN
PL= $5 P
K= $1
12
9
8
9
$12
( 4 ) COST WHEN P
L= $1 P
K= $1
210E
36D
(2)UNITS OF
CAPITAL (K)
( 3 )UNITS OF LABOR (L)
Cost-Minimizing Choice Among Alternative Technologies (100 Diapers)
44C
63B
102A
(1)T E C H N O L O G Y
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Review Terms and Concepts
Accounting costsAccounting costs
Average productAverage product
CapitalCapital-- intensive technologyintensive technology
Economic costsEconomic costs
Economic profitEconomic profit
Explicit costsExplicit costs
FirmFirm
Homogeneous productsHomogeneous products
Implicit costsImplicit costs
LaborLabor-- intensive technologyintensive technology
Law of diminishing returnsLaw of diminishing returns
Long runLong run
Marginal productMarginal product
Normal rate of returnNormal rate of return
Optimal method of productionOptimal method of production
OutO u t --o fo f--pocket costspocket costs
Perfect competitionPerfect competition
productionproduction
Production function or total product functionProduction function or total product function
Production technologyProduction technology
Profit (economic profit)Profit (economic profit)
Short runShort run
Total cost (total economic cost)Total cost (total economic cost)
Total revenueTotal revenue
Appendix: Isoquants and Isocosts
• An isoquant is a graph that shows all the combinations of capital and labor that can be used to produce a given amount of output.
Appendix: Isoquants and Isocosts
31021018E473625D
554433C746352B
10310281ALKLKLK
qx= 150q
x= 100q
x= 50
Alternative Combinations of Capital (K) and Labor (L) Required to Produce 50, 100, and 150 Units of Output
Appendix: Isoquants and Isocosts
• The slope of an isoquant is called the marginal rate of technical substitution.
L
K
MPK
L MP
?? ?
?
• Along an isoquant:
LK MPLMPK ??????
Appendix: Isoquants and Isocosts
• An isocost line is a graph that shows all the combinations of capital and labor that are available for a given total cost.
• The equation of the isocost line is:
LPKP LK ???
Appendix: Isoquants and Isocosts
• Slope of the isocost line:
/
/K L
L K
TC P PK
L TC P P
?? ? ? ?
?
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Appendix: Isoquants and Isocosts
• By setting the slopes of the isoquant and isocost curves equal to each other,
L L
K K
MP P
M P P?
L K
L K
MP M P
P P?
we derive the firm’s cost-minimizing equilibrium condition is found
Appendix: Isoquants and Isocosts
• Plotting a series of cost-minimizing combinations of inputs (at points A, B, and C), yields a cost curve.
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In the chapter on Supply and Demand we limited our attentionto the supply and demand for consumer goods, to keep thingsa little simpler. In this chapter we extend the supply anddemand approach to cover markets for resources, or, in theeconomist’s traditional jargon, factors of production. We willdiscuss markets for• labor• land• natural resources• capitalPeople demand consumer goods for the direct benefits ofconsuming them. That’s not true of labor, land and capital.These factors of production are demanded in order to use themin producing consumer goods. In other words, the demand forfactors of production is a “derived demand” — that is, it isderived from the demand for the consumer goods. When afirm demands resources in order to produce potatoes (forexample) the firm’s demand for resources will depend on twothings: the demand for potatoes, and the productivity of theresources in producing potatoes. To be more precise - drawingon ideas from preceding Chapter - it will depend on the marketprice of potatoes and on the marginal productivity of theresources in producing potatoes.We will take up where we left off in Chapter 2 & 3, with thedemand for the human resource: labor.
Notes
UNIT IVTHE MARKET STRUCTURE AND THE
FACTORS MARKETCHAPTER 7:
FACTOR MARKET
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LESSON 27:DEMAND AND SUPPLY IN FACTOR MARKET
27.1 Demand and Supply in CompetitiveFactor MarketsFactor markets are much like output markets, but with oneimportant difference. The demand for factors is a deriveddemand. For example, a firm’s demand for labor depends uponhow much output the firm will produce. More output leads toa greater demand for laborers, less output leads to a lowerdemand for laborers.Consider the case where there is one variable factor called laborand that this labor is bought and sold in a competitive labormarket. The use of the term competitive designates a situationthat is similar to what we would find in a competitive outputmarket. In this case, each buyer of labor is one of many buyersin the market. The labor market determines the wage facingindividual buyers, who purchase as many workers as needed atthe given wage rate. As a result, the supply of labor facing anyindividual buyer is a horizontal line at the going wage rate. Thegraph below shows this.
The quantity of labor hired by each firm depends on where themarginal benefit of each hired factor equals the cost of hiringthat factor. The marginal benefit (MB) is given by how eachextra laborer affects the firm’s revenues, whereas the marginalcost (MC) of each additional laborer is how each laborer affectsthe firm’s total costs. In equation form, MB and MC are givenas:MB = DTR/DLMC = DTC/DLBecause firms can hire as many workers as needed at the existingwage rate, we know that the second equation (which describesthe supply of labor) can be rewritten as MC = w.The first equation (which gives us the demand for labor) can berewritten as: MB = (DTR/DQ)(DQ/DL). That is, the marginalbenefit of hiring additional workers is the product of a firm’smarginal revenue and marginal product of labor.Note that marginal revenue is determined by the firm’s outputdecision in the output market, while marginal product isdetermined by the firm’s hiring decision in the factor market.Because a firm’s marginal revenue curve depends on the marketstructure of the output market, the firm’s demand for labor will
depend on the market structure in the output market as well.For example, if a firm operates in a perfectly competitive outputmarket, then the firm’s marginal revenue is equal to the marketprice. If a firm is a monopolist in the output market, then thefirm’s marginal revenue is less than the price.Let’s compare the demand for labor between a perfectlycompetitive industry and a monopoly that operate in identicaloutput markets. Assume that both industries draw from thesame labor market (e.g. the unskilled labor market) and thatthere are many other firms doing the same thing.The demand for labor by firms in any industry is the productof marginal revenue and the marginal product of labor.Perfectly competitive firms have a marginal revenue that equalsthe market price (i.e. MR = P). If MR = P, then we can rewritethe demand for labor by firms in a perfectly competitiveindustry as (P x MPL). This term can be refered to as themarginal value product of labor (MVPL).Monopolists produce where their marginal revenue is less thanthe market price. Therefore, we cannot rewrite the monopolist’sdemand for labor as (P x MPL). The monopolist will have ademand for labor equal to (MR x MPL), which we call themarginal revenue product of labor (MRPL).
27.2 Monopsonist Factor MarketIn output markets with only one seller, there is monopoly.When there is only one buyer in a factor market, we havemonopsony. A key difference between monopsonistic andcompetitive factor markets is how total costs change with thepurchase of additional factors.For example, in a competitive labor market, firms may purchaseas many laborers as needed at the market wage because eachfirm’s labor supply curve is horizontal. Because a monopsonistis the only buyer of labor in a particular labor market, themonopsonist faces the entire (positively sloped) market laborsupply curve. The difference is clearly important when consider-ing the marginal cost of hiring each additional worker.When facing a positively sloped market supply curve, the firm’stotal costs change with the hiring of additional workers asfollows:DTC = wDL + (Dw)LIf we divide both sides of the equation by DL and thenrearrange, we have:DTC/DL = w + (Dw/DL)LThis equation is refered to as the marginal expenditure of labor.Note that the marginal expenditure of labor (or marginal costof hiring additional workers) is greater than the wage here.Therefore, the marginal expenditure curve is steeper than themarket labor supply curve.
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In addition, because the monopsonist hires a quantity of laborthat coincides with where the marginal cost of hiring eachadditional worker equals the marginal benefit of each additionalworker, the firm hires at the point where the firm’s demand forlabor equals the marginal expenditure for labor. This isillustrated on the graph below.
On the graph, the marginal expenditure equals the firm’sdemand for labor at the quantity QM. To get this quantity ofworkers to supply labor, the firm must pay a wage that comesfrom the labor supply curve. On the graph, that wage is wM .Contrary to the monopsonistic market, hiring in a competitivelabor market occurs where the demand for labor equals thesupply of labor. To provide a comparison with a similarmonopsonistic labor market, the competitive market equilib-rium values are included in the graph as well (QC and wC). Notethat a monopsonist would hire less labor and pay a lower wagethan what would result in competitive labor market with similardemand and supply conditions.
27.3 Different Factor MarketsIn the short run, let’s assume that labor is the only variablefactor hired by different firms. Equilibrium in the marketdepends on two things. First, we must know whether the firmsbuying labor are competitive or monopolistic in their respectiveoutput markets. Second, we must know whether the labormarket itself is competitive or monopsonistic. These differentsituations are illustrated below.Assume that the labor market is competitive, so that firms hirewhere demand equals supply. In this situation, firms face ahorizontal labor supply curve. If the firm is perfectly competi-tive in its output market, then its labor demand curve is calledthe marginal value product (MVP). If the firm is a monopolistin its output market, then its labor demand curve is called themarginal revenue product (MRP).
The graph (above) on the left represents the perfectly competi-tive firm buying labor from this competitive labor market,
whereas the graph on the right represents the monopolistic firmbuying labor from this competitive labor market. In each case,labor is hired and paid a wage that corresponds with the pointwhere the demand for labor equals the supply of labor.If the labor market involves monopsony, then firms hire wheretheir marginal expenditure curve crosses their demand for laborcurve and pay a wage that corresponds with the labor supplycurve. Depending on whether the firm is perfectly competitivein its output market or monopolistic, the firm’s demand forlabor is either called the marginal value product curve (left graphbelow) or the marginal revenue product curve (right graphbelow).
In both situations, and in the absence of any unionization, thewage is determined by where the vertical dotted line (comingdown from the intersection of either MVPL and MEL to Q* onthe left graph or from MRPL and MEL to Q* on the rightgraph) crosses the labor supply curve. The wage in each case isgiven as w*.
27.4 Factor Markets and SurplusJust as in output markets, factor markets give rise to consumerand producer surplus. We can define these surpluses in thesame manner as with output markets. Consumer surplus in afactor market is the difference between maximum acceptablefactor price and the actual factor price for all units purchased.Producer surplus becomes the difference between the actualfactor price and the minimum acceptable factor price for all unitspurchased.Let’s consider a world where there is only one variable factor(labor). In a competitive labor market, firms hire where theirlabor demand equals the existing labor supply. Considering thelabor market as a whole, this implies an equilibrium such as thatfound in the left-side graph below. Consumer surplus is thegreenish area bordered by wC and DL - all the way out to QC.Producer surplus is the purplish area bordered by wC and SL - allthe way out to QC. These surpluses are labelled as CS and PSrespectively.
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If the labor market is monopsonistic, then the monopsonisthires labor to the point where MEL crosses DL. The wage (wM)comes from the point on SL that is directly above QM.Because MEL is above SL, the monopsonist hires less labor thanwould be hired in a more competitive labor market. As a result,the surpluses change in size. Consumer surplus extends downinto former producer surplus, whereas producer surplusshrinks. If labor is not hired at the point where demand equalssupply, then we also have some deadweight loss (given in thegraph as the tan area called DWL).Although the existence of DWL implies an inefficient allocationof labor, the size of this area can differ across otherwise similarlabor markets. This is because DWL results from the substitu-tion that occurs within the demand or supply side of themarket. For example, the graph below shows that an increas-ingly inelastic labor demand curve decreases the size of DWL.As the labor demand curve becomes steeper, we realize that thelabor from other labor markets is an increasingly poorersubstitute for the labor in this market. At the extreme, whereDL is perfectly inelastic (i.e. DL is vertical), there would be noDWL at all.
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1. Multiple Choice Questions
Top of Form
1. A perfectly competitive firm is operating at an output whereprice is greater than marginal cost. Therefore:
• the firm should produce more to maximize profit.• the firm should produce less to maximize profit.• the firm is making a profit.• the firm is taking a loss.• the firm should shut down.2. If your new business (in which you have invested $50,000,
which you previously kept in savings, earning 10% interest)earns an accounting profit of $30,000 in the first year, andyou had previously been employed as a ditch-digger, earning$10,000 per year, your economic profit is:
• -30,000.• -15,000.• $0.• $15,000.• $20,000.3. Fill out Table 1, and use it to answer the following three
questions.Table1
Q VC TC MC0 0 50 —1 10 2 30 3 60 4 100 5 150 If the price of the product is $40, at what output does this firmmaximize profit?• 1• 2• 3• 4• 54. Refer to Table 1. If the price of the product falls to $20, what
should this firm do?• produce 0 (shut down) because profit is less than zero• reduce production to 1• reduce production to 2• reduce production to 3• do nothing; the choice is still optimal
5. You’ve been hired by an unprofitable firm to determinewhether it should shut down its operation. The firmcurrently uses 70 workers to produce 300 units of output perday. The daily wage (per worker) is $100, and the price of thefirm’s output is $30. The cost of the other variable inputs is$500 per day. Although you don’t know the firm’s fixedcosts, you do know that they are high enough that the firm’stotal cost exceeds total revenue. What is the bestrecommendation you can make, based on the informationthat you have?
• exit the industry in the long run• shut down in the short run• continue to produce in the short run• continue to produce in the long run• not enough information to tell6. Which of the following conditions exist in long-run
competitive equilibrium?• P = LRAC• Individual firms operate at the most efficient scale of plant.• The level of output produced coincides with the minimum
point on the LRAC curve.• All of the above.7. Assume that a perfectly competitive industry is in long run
equilibrium. If demand increases, which of the followingwill occur?
• market price will increase.• firms will produce more output.• firms will increase their profits.• the industry will not be in long-run equilibrium.• All of the above are correct.8. Think about a graph showing per-unit cost and revenue
numbers for a competitive firm in the short run. Whencomputing the amount of profit obtained from any level ofoutput produced in this graph, which of the curves below isNOT necessary?
• The firm’s demand curve.• The SATC curve.• The MC curve.• None of the above. All of these three curves are necessary to
estimate the amount of profit.9. Think about a graph showing per-unit cost and revenue
numbers for a competitive firm in the short run. Todetermine what level of output the firm should produce inorder to maximize profit, one of the curves below can bediscarded. Which one?
TUTORIAL 6
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• The firm’s demand curve, either D0 or D1.• The SATC curve.• The MC curve.• None of the above. All of these curves are necessary.10.The firm’s short-run supply curve is:• the marginal cost curve.• the marginal cost curve above average variable cost.• the marginal cost curve above average total cost.• the total cost curve.• the total revenue curve.11.Refer to Figure 1. At a price of $15, how much should the
firm produce?
Figure 1
• 0• 10• 50• 60• 7012.Refer to Figure 1. What is the lowest price at which this firm
will produce anything?
Figure 1
• $8• $10• $15• $20• $2213.Refer to Figure 1. What is the lowest price at which this firm
can break even?
Figure 1• $8• $10• $15• $20• $2214.When a firm expands its scale of operations, and such
expansion leads to lower cost per unit, the firm faces:• Constant returns to scale.• Decreasing returns to scale.• Increasing returns to scale.• Diminishing returns.15.A firm exhibits economies of scale:• Along the decreasing portion of the long-run average cost
curve (LRAC).• Along the increasing portion of the long-run average cost
curve (LRAC).• Exactly where LRAC reaches its minimum point.• Anywhere along the LRAC, as long as increasing the scale of
operations does not affect cost per unit.16.If the fast-food industry is known to be a constant cost
industry, which of the following best explains the effect ofan increase in demand?
• In the short run, prices will rise, inducing firms to enter, andcausing the price to return to the original price in the longrun.
• In the short run, prices will rise, inducing firms to enter, andcausing the price to fall but remain higher than the originalprice in the long run.
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• In the short run, prices will rise, inducing firms to enter, andcausing the price to fall below the original price in the longrun.
• In the short run, prices will fall, inducing firms to exit, andcausing the price to return to the original price in the longrun.
• In the short run, prices will fall, inducing firms to exit, andcausing the price to fall below the original price in the longrun.
17.When the long run supply curve is horizontal,• The industry is a constant-cost industry.• The industry is a decreasing-cost industry.• The industry is an increasing-cost industry.• The industry experiences external economies.18.Why is the long-run supply curve expected to be flatter than
the short-run supply curve?• because entry of new firms drives up input costs in the long
run• because firms experience diminishing returns in the short
run but not the long run• because demand is more likely to increase in the short run• because firms cannot adjust inputs in the long run• because economic profit must be zero in the long run19.Decreasing-cost industries occur when:• input prices rise as the industry expands output.• input prices remain constant when the industry expands
output.• input prices fall when the industry expands output.• the long-run supply curve shifts leftward.• the long-run supply curve shifts rightward.20.In the long run, entry will occur in a perfectly competitive
market:• as long as economic profits are greater than zero.• as long as there are no barriers to entry.• as long as demand is increasing.• as long as price is greater than short-run average variable cost.• all of the above
2. Long Answer Questions1. Explain both the potential benefits and potential costs of
allowing mergers. Under what circumstances is theDepartment of Justice most likely to allow mergers? Underwhat circumstances are mergers most likely to be disallowed?
2. How did the deregulation of air travel affect the price of airtravel?
3. Case Study - IAuto Insurers and Price Discrimination
LEAD STORY-DATELINE: The Wall Street Journal,Wednesday April 7, 2004.Automobile insurers have practiced price discrimination foryears. Good student discounts, multiple policy discounts, and
discounts based on driving record are all ways to segment themarket and practice price discrimination. Now some insurancecompanies are experimenting with 5% to 10% occupationdiscounts.Farmers Insurance Group offers residents in some statesdiscounts if they are police officers, firefighters, nurses,scientists, engineers, or medical doctors. Other insurers haveextended these discounts to include teachers. Many of thesediscounts are pilot programs that will be extended if successful.One of the primary reasons the programs have yet to beexpanded is the problem of occupation verification. For now,many rely on customer honesty. Other companies do spotchecks. And ironically, while many of these programs offerdiscounts to medical doctors, this occupation is the secondhighest accident-prone profession calculated using number ofaccidents per 1,000 individuals. Students rank at the top withmore accidents than any other group.
Thinking About the Future!Now that you are aware of price discrimination, I suspect youcan identify several more examples. Look around and see whatother businesses practice price discrimination and see how theyaccomplish this task. For example, think about how bankssegment customers into groups that receive different prices.
Talking It Over And Thinking It Through!
1. What is price discrimination?2. Why would a firm practice price discrimination?3. Provide some other examples of price discrimination.
4. Case Study - IIWill Andersen Conviction Benefit Enron’s Shareholders?LEAD STORY-DATELINE: Wall Street Journal, June 19,2002.Arthur Andersen LLP’s conviction looks like it could provideammunition to Enron Corp. investors suing the accountingfirm. Not only did the government’s recently concluded criminaltrial provide damning testimony about Andersen’s activities, theguilty verdict will be admissible in civil cases. This particularjudgment, however, will not help Enron shareholders get theirhands on any cash. Since Andersen will cease auditing publiclyowned clients by August 31, the firm’s financial picture ismurky. This means plaintiffs’ prospects for financial recovery intheir civil cases increasingly will ride on their ability to holdEnron’s banks and law firms liable. Under federal securities law,however, plaintiffs will have to prove the firms had intent todefraud or were recklessly indifferent.Another potential source of recovery for Anderson and for theplaintiffs might come from Andersen’s overseas affiliates whichare required by their contracts to pay 1.5 times last year’s revenueto break away. To date, June 2002, few of these payments havebeen made. Still, the Enron shareholder claims are “contin-gent,” meaning that it hasn’t yet been determined how much, ifanything, Andersen will owe on them. If Andersen files forbankruptcy-court protection before closing its doors, litigantswould have to take their claims to bankruptcy court, then standin line with other unsecured creditors for a piece of the remain-
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ing cash. One advantage for the plaintiffs, the burden of proofin civil claims is far lower than that in criminal cases, such as thegovernment’s successful action against Andersen. The lawsuiton behalf of Enron employees alleges that Enron and itsbankers conspired to defraud Enron workers out of theirretirement money. If proven, J.P. Morgan & Co., Citigroup Inc.,Credit Suisse First Boston, and Vinson & Elkins would bewelcome sources of collection for potential damages.The limits to limited-liability partnerships, designed to shieldits partners from the liabilities of the firm, have never beentested. Most legal beagles believe LLP shields partners frommalpractice claims, but don’t extend to partners implicated inwrongdoing. What does all this have to do with economics? Wewill explore those implications as we talk it over and think itthrough. The potential damage to the economy and to futureeconomic policies is far-reaching.
Thinking About the Future!Frank Savage was a board member of Enron and of theinvestment firm Alliance Capital Management, which untilrecently was Enron’s largest institutional investor. Alliance wasdangerously close to last in selling Enron stock. Alliance boughtlarge blocks of the stock on August 15, 2001-the day after CEOJeffrey Skilling resigned-and continued to buy even afterEnron’s October 22 announcement that it was under investiga-tion by the SEC. By the time Alliance sold its 43 million sharesof Enron stock, it had lost hundreds of millions of dollars forits investors, including $334 million from the Florida statepension fund. Governor Jeb Bush and state officials suedAlliance for negligence. As a board member of both companies,Savage deserves special recognition for poor business judgmentor worse. Nell Minow, a corporate watchdog running the Website The Corporate Library, and others are developing ratingssystems for board members based on factors such as attendanceand prior performance. In this way, board members such asSavage may be shamed into early retirement from corporateboards. Ironically, however, the impetus for reform may bemoney. Taking a plank from the idea of “market efficiency,” theinsurance industry is eager for director rankings. This industryfoots the bill when boards like Enron’s fail. In the future, withAdam Smith-styled markets back to work, companies withlousy boards will pay hefty premiums for directors’ and officers’insurance. Markets work, but not to benefit everyone equally.That’s the rub, or is it?
Talking it Over and Thinking it Through!
1. Why is it economically important to protect shareholdersrights and provide restitution to shareholders when theirlosses are due to fraud?
2. Adam Smith’s invisible hand of the market - whichtranslated the pursuit of self-interest into public benefit -recently has been interpreted to mean that our self-interest inthe stock market’s performance would benefit the public. Arethere different consequences for greed than for AdamSmith’s concept of self-interest? Why or why not?
3. Sometimes markets are described as if they operateindependently of other institutions such as property rights
and the judicial system. What lesson can be learned from theAndersen/Enron case regarding this seeming independence?
4. During the past two decades, the Securities and ExchangeCommission (SEC) has been very lax in its oversight ofcorporations and of the markets. Do you believe that itshould become more vigilant since the Andersen/Enroncase? Why or why not?
5. What was the essential reason for the establishment oflimited liability partnerships (LLPs)?
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LESSON 28:LABOUR
1. Profit Maximization and The Demandfor LaborAs we learned in Previous chapter, the way to maximize profitsthen is to hire enough labor so thatVMP=wagewhere the wage is the price of labor, per hour or week or year asthe case may be, and VMP stands for the Value of the MarginalProduct. In turn the VMP is defined as follows:VMP=p*MPwhere p is the price of output and MP is the marginal produc-tivity of labor in units of output. We may think of the VMP asthe marginal productivity of labor in money terms.Using the example of producing potatos, p would be themarket price of potatos, MP would be the marginal productiv-ity of labor in the potato industry. We recall the definition ofmarginal productivity of labor:the additional output as a result of adding one unit of labor,with all other inputs held steady and ceteris paribus.Thus, the value of the marginal productivity (in the potatoexample) is the market value of the additional potatos pro-duced by one additional worker in the potato industry.Let’s use these ideas to visualize the demand for labor. On thispage, we will make one simplifying assumption: the price of theoutput (the price per bushel of potatos, for example) is heldconstant as the wage varies for an individual firm. (We’ll see inthe next page what difference the simplifying assumptionmakes).We can visualize the VMP and the wage as in the followingfigure:
Figure 1: VMP=wageAs the wage drops from W 1 to W 2 and then to W 3, we see thedemand for labor increasing from N1 to N2 and then to N3. The
firm is moving down the curve of diminishing marginalproductivity, and the cheaper labor is, the more sense it makesto move further down that curve, and the further down thecurve the profit-maximizing labor input is.What this is telling us is that (with the output price constant)the VMP curve is the firm’s demand curve for labor. Rememberthe definition of a demand curve: it tells us, for each price, whatwill be the quantity demanded. The price of labor is the wage,and the VMP curve tells us, for each wage, what is the quantityof labor demanded.
a. A Complication
But, in general, the price of the output will not remain steady asthe wage changes. Here’s the reason: if labor is cheaper, to theindustry as a whole, that will shift the industry supply curve tothe right. That will lead to lower prices for industry output.This leads to the slightly more complicated diagram in figure 2:
Figure 2: Changing Output PricesAs the wage drops from W 1 to W2, the price of industry outputdrops from p to p’, shifting the pMP curve to the left. The newpMP curve is shown by the dotted green line. This leads to anew profit-maximizing labor input at N2. This means that theindustry demand curve of labor is actually a little steeper thanthe VMP curve for a constant output price
b. Labor SupplyThe supply and demand approach is based on both — supplyand demand. So we need to consider the supply as well as thedemand for labor.Any individual worker’s supply of labor will depend on her orhis opportunity for income from sources other than labor andon her or his preferences between leisure and earning income.When we look at the supply of labor from the point of viewof the economy as a whole, this can lead to some surprises.Some economists argue that the labor supply curve could slopebackward, for at least a part of its range. This is shown in figure3, below.
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Figure 3: Supply of Labor to the Economyas a Whole — Perhaps
Here is the idea: when people earn a higher wage per hour, theycan earn more income for working the same or even fewerhours. When people can “have it all,” they often choose to dojust that — have more of all the good things. Thus, whenwages per hour of labor rise, people are getting better off, andeventually they decide to take some of their increased potentialincome in the form of leisure rather than money. That meansthe quantity of labor supplied — in hours per year — is less,and the labor supply curve slopes backward (as shown) at thehigher wage levels.When we look at the supply of labor to a particular industry, wedon’t need to worry about this. For example, when wages paidby the potato growing industry are low, most people will findthat they can make more money in other industries, and so theydon’t supply labor to the potato industry. When potato growerwages rise, some of those people will find that they now canearn more in the potato industry than in their alternatives, andwill switch their labor supply into the potato industry. Thus,the supply curve of labor to the potato industry will be upwardsloping. Since the supply of labor to a particular industry isdominated by this switching-back-and-forth from otherindustries, the supply curve of labor to an individual industrywill usually be upward sloping, From now on, we will showthem as upward sloping.
c. Equilibrium in the Market for Labor
Now we can put the supply and demand for labor together anddiscuss an equilibrium. This is shown in Figure 4, below. Recall,the price of labor is the wage, shown by w, and the quantitydemanded is the number of labor-hours employed, shown byN. The demand for labor is the pMP, the price of output timesthe marginal productivity of labor in units of output. As usual,the equilibrium price (wage) and the equilibrium quantitydemanded and supplied (employment) are at the point wherethe supply and demand curve intersect.
Figure 4: Supply and Demand for Labor in an Industry“The proof of the pudding is in the eating,” so let’s look at anapplication.
2. Labor Market with a Minimum Wage Law
One important application is to analyze the effects of aminimum wage law. This is shown in Figure 5, below. In thefigure, the minimum wage is at W, above the equilibrium wage.As a result, employers will demand and hire only Nd labor-hours, less than would be hired at the equilibrium wage. On theother hand, Ns labor hours are supplied, and we have an excesssupply.
Figure 5: Supply and Demand for Labor with a MinimumWage Law
Workers still employed under the minimum wage law arepresumably better off, but there are workers offering Ns-Nd
labor hours who cannot find jobs in the industries covered bythe minimum wage. What are they to do? They mighta. Shift into industries with equilibrium wages above the
minimum wage.But most will not be able to do this — if they could get jobsat higher than minimum wages, they probably would havedone it already.
b. Shift into industries that pay less than the minimumwage but are not covered by the minimum wage law.
Over time, the number of such industries has decreased, butthere are still some. They will be working for lower wages andbe worse off in this case.
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c. Become self-employed in some very small enterprise.Again, they will presumably obtain less income and be worseoff — otherwise, we would suppose that they would haveshifted before the minimum wage law was enacted.d. Drop out of the labor force entirely.Some may retire, or rely on the income of spouses or relatives,while some may drop out of the legal labor force to engage inillegal “hustling” for an income.e. Become unemployed.Unemployment is really a macroeconomic concept, but in thesimplest terms people who are looking for a job and notfinding one are said to be unemployed.Many economists believe that a portion of them will becomeunemployed. In any case, this analysis leads the majority ofeconomists to believe that minimum wage laws are a poorpolicy. Presumably they are intended to help wage-earners, butat least some wage-earners are worse off as a result of theminimum wage laws. While there has been some controversy inall this, and the controversy has been renewed in the ‘nineties, ithas not shaken the predominant feeling of economists thatminimum wage laws have some very undesirable side-effects.
3. Criticism of the Supply-and-Demand Approach toLabor Markets
Not all economists would accept the supply-and-demandanalysis of labor markets, employment and wages. There areseveral criticisms of the supply-and-demand model of labormarkets and the John Bates Clark model of the business firm.Each of the criticisms could lead to an alternative analysis oflabor markets. Since this is not a text of labor economics, wewill just mention the criticisms, but not attempt to sketch thealternative analyses. Critics mention the following points,among others:• Wages and income distribution may be influenced or
determined by bargaining power.• Labor unions can create bargaining power for employees• Employers may limit wages because of limited
competition for employees and by means of wagediscrimination.
• Perceptions of fairness may influence wages and workingconditions.
• Productivity itself may be influenced by wages and workingconditions.
• The Marxist view is that employment is a social relationshipbased on exploitation, and that wages and labor cannot beunderstood except in those terms.
4. Criticisms Related to Bargaining PowerSome critics stress the importance of bargaining power ininfluencing wages and employment, shifting them away fromthe supply-and-demand equilibrium or replacing supply anddemand completely as the determinant of wages. Bargainingpower may be exercised by employers or employees or both:• Employers may influence the wage by restricting their hiring.
When the wage is below the supply-and-demandequilibrium, employers find it profitable to hire more
workers at the going wage, but hiring the additionalworkers could force wages higher (moving upward along thesupply curve of labor), leaving the employers worse off onnet. Conversely, the employers as a group may have higherprofits with less labor, but a lower wage — lower on thesupply curve of labor. Strong competition for employees, inwhich each employer offers higher wages to get moreemployees according to their marginal productivity, wouldeliminate the low wages and lead the labor market to thesupply-and-demand equilibrium. However, if employers canavoid this competition for labor, they can keep wages downand profits higher. Some critics believe this is possiblebecause labor markets are typically segmented by skill,experience and location. As a result of this segmentation,they feel many labor markets are dominated by one buyer(called monopsony) or a few buyers (called oligopsony).
· Employers may also keep their wage costs down bydiscrimination, paying different wages to different workersand, as nearly as possible, paying each one the minimumnecessary. Some employees may accept lower wages thanothers because their alternatives are limited by gender, race,age, disability, or unpredictable personal characteristics.Having worse alternatives, they may accept lower pay andthus allow employers to expand their work forces withoutmoving up the labor supply curve and paying higher wagesoverall. Again, strong competition for labor would tend tolimit (perhaps not eliminate) wage discrimination.
• On the employees’ side, labor unions can favor theemployees’ bargaining power (again) by limiting competitionfor jobs among the employees and potential employees.Where this is very successful, it leads to collectivebargaining between employers and employees. That is, theunion or a group of unions, and the employer or a group ofemployers together negotiate a contract that determineswages and conditions for a whole group of employees,sometimes a whole industry or group of industries. Thisfactor may be exaggerated — only about 20% of theAmerican labor force is unionized — but unions are moreimportant in some other industrialized countries andcollective bargaining settlements may influence the wages andconditions for non-unionized employees. Also, a group ofemployees may find means of limiting their competition inthe absence of unions.
• In the absence of any union, when wages are determined byindividual bargaining, the bargaining power of theindividual workers may be an important influence on wages.This is especially likely when employers practice wagediscrimination. However, the average bargaining power ofthe individual worker may be increased or decreased bygeneral conditions in society, such as the distribution ofpolitical power and — of course! — the overall balance ofsupply and demand for labor.
These criticisms lead a minority of economists to question theanalysis of minimum wage laws given in an earlier page. In thatdiscussion, a minimum wage law leads to a decrease in employ-ment as the market moves up the demand curve for labor. Butin some of the models based on bargaining power, employ-
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ment is not on the labor demand curve. In that case, the impactof a minimum wage law on unemployment is unpredictable.
5. Perceived FairnessFairness is, of course, normative economics — to say thatsomething is fair is to say that “it ought to be.” But a minorityof economists believe that perceptions of fairness may have aninfluence on wages paid. This is especially likely if bargaining(either collective or individual) plays a role in determining wages.If workers see a low wage offer as “unfair,” they may be morelikely to resist it, making it more difficult for employers to insiston it. And employers may be more likely to agree to a wagedemand if they perceive it as “fair.”Thus, perceptions of normative economic concepts, such asfairness, can have an impact on “what is,” positive economics.But perceptions are changeable and may depend on wider socialattitudes and customs. For example, it appears that employersare less concerned with “fairness,” and more determined tomaximize profits by reducing wage costs, in recent years thanthey had been in the “good old days.” In recent years socialattitudes have been more accepting toward this sort of competi-tion, and it may be that this accepting attitude has changed thebehavior of business. But it may be that only the rhetoric haschanged, and that employers are more open about theirdecisions than they were when social attitudes were lessfavorable to “profit maximization.”Unfortunately, we know very little about the impact of per-ceived fairness, but we cannot rule it out as a factor in wagebargaining.
6. Effects of Wages and Working Conditions onProductivity
The supply-and-demand approach as we have seen it hereassumes that the marginal productivity curve remains un-changed as wages and working conditions change. But there issome evidence that a change in wages or working conditions canshift the marginal productivity curve upward or downward,changing the relationship between the number of units oflabor employed and the marginal productivity of labor. Inparticular, a cut in wages may shift the marginal (and average)productivity downward.• In very poor countries, lower wages may lead to reduced
nutrition and worse health for the employees, and thus tolower productivity.
• In richer countries, a wage above the employee’s alternative(that is, above the supply curve) can limit the turnover of thework force. Turnover is costly in itself, and with less turnoverthe employees have more opportunity to learn to work welltogether, increasing productivity.
• Wages above the supply curve can also increase the incentiveto work hard and to “work smart.” If wages are only on thesupply curve, then the worker has less to lose if she or he isdismissed on grounds of not working hard enough.
• The perceived fairness of a wage above the supply curve mayalso make the employees more willing to work hard and to“work smart.”
Now, suppose that an employer cuts the wages (starting abovethe supply curve of labor) in the hope of cutting overall costsand so increasing profits. Let’s call that the direct cost effect.At the same time, the lower wages shift the marginal andaverage productivity downward. This increases costs, offsettingthe wage cut. Let’s call that the productivity effect. Profits mayeither increase or decrease, depending on whether the direct costeffect is bigger than the productivity effect. Some economistsargue as follows: when wages are very high, the direct cost effectwill be greater than the productivity effect; but as wages dropthe productivity effect will increase and the direct cost effect willdecline, so that there is a particular wage (above the supply curveof labor) that gives maximum profits. This is called the“efficiency wage.”If market wages are often efficiency wages, then labor marketscould behave quite differently than the John Bates Clark supplyand demand approach suggests. But what is the evidence?
7. Evidence on Productivity Effects
We have little direct evidence on the efficiency wage hypothesis,but there is a good deal of evidence on related issues.• Profit sharing is a form of labor compensation in which the
employees get higher wages when company profits arehigher. The idea is that profit sharing increases the incentiveto work harder and “work smarter,” and thus increasesprofits. On the whole, the studies confirm this, showingthat there is at least some scope for increasing profitsthrough the productivity effect.
• Studies of unionization provide evidence that, on the whole,unionized companies have higher labor productivity thannon-unionized companies (except, of course, when theunion is on strike!) This is a surprising result, and there hasbeen some controversy about how to explain it. Onepossible explanation is that the higher productivity comesfrom the productivity effect of better wages (and workingconditions) the unions were able to obtain. The productivityeffect does not seem to increase profits in this case, however.Apparently the increase in productivity is just about balancedout by the increase in wages.
• A cooperative enterprise is an enterprise in which thedirectors and officers are elected directly by the employees.The employees may be the owners of the enterprise or theenterprise may be owned by some nonprofit, public, orphilanthropic agency. Such enterprises have existed in variousparts of the world (including the United States, Britain, andother “capitalist” countries) for over 150 years. Studies ofcooperative enterprises show that they generally do betterthan investor-controlled or government enterprises in laborproductivity, although they can have difficulty raisinginvestment capital. Presumably they are benefiting from alarge productivity effect, although money wages may not bethe main reason for it — because of their difficulties raisinginvestment capital, their wages are not necessarily high.
• Many other enterprises are more or less compromisesbetween investor-controlled and cooperative forms. Forexample, the employees may elect a certain proportion of theBoard of Directors. This is called Codetermination. In
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Germany all of the large corporations are required to havehalf of the members of their Boards of Directors elected bythe employees. This is called Codetermination with Parity.International comparisons are difficult, but the Germaneconomy has certainly been a strong performer, with highlabor productivity, very high wages, and a very strong exportbalance. Comparisons of different enterprises withincountries are easier. Studies of this kind have comparedenterprises that come nearer the cooperative end of thespectrum with other enterprises that are nearer the investor-controlled end of the spectrum and, allowing for somedifferences in circumstances, the more nearly cooperativeenterprises have had higher labor productivity on the average.
Thus, there is some evidence that productivity effects canbe important, but the evidence also suggests that theorganization of the enterprise is at least as important as themoney wage level in creating productivity effects.
8. Marxist Labor Economics
For Marxism, of course, labor and employment are the centralconcepts of social science. However, a Marxist would reject notonly the supply-and-demand approach to labor markets, butmany of the neoclassical criticisms and alternative models of“labor markets.”We can only sketch a few concepts of Marxism here. From theMarxist point of view, only labor is productive, so that allproduction is attributable to labor. Marxist ideas were devel-oped before the marginal productivity approach was known,and so marginal productivity plays no role in the Marxistapproach. Many Marxists would see the marginal productivityapproach as relevant only in the short run; by contrast, theMarxist analysis is a long period analysis.Also, of course, Marxism accepts the labor theory of value. Thisis the meaning of the phrase “only labor is productive:”specifically, only labor produces value.Marxism says that, in the long run, the price of any commodityis the same as its average cost. Cost and price are measured inlabor value, so this is the same as saying that, in the long run,the price is equal to the value. Since labor is a commodity in acapitalist system, the price of labor — the wage — will be equalto the average cost of production of labor. Since the productiv-ity of labor is greater than its average cost of production, laborproduces some surplus that is not paid out as wages, even inthe long run. In turn, the cost of production of labor is itselfmeasured in labor value, so we are saying that labor creates morevalue than is required to produce the labor. The difference, interms of labor value, is called “surplus value.” Surplus value isthe source of profits in a capitalist systemThus, on the Marxist view, labor is “exploited” through thewage employment system, which transfers the surplus value oflabor to the capitalist class. In the short run, this can be offset orexaggerated by such factors as monopoly power, temporaryscarcities of investment funds, machinery or natural resources,or political interference in the marketplace. In this context,marginal productivity may play its short-run role. The laborvalues define a typical capitalist system, in that prices in any realperiod tend toward the labor values. If, hypothetically, a
capitalist system were to exist for an indefinite period withoutany new disturbing factors, the prices would eventually equal thelabor values. However, no capitalist system could exist for anindefinite time — the same tendencies will produce a revolutionand lead to some new kind of system. Nevertheless, Marxistsregard the surplus-value theory as the correct general explanationof profits and the most useful intellectual tool for understand-ing wages, labor and employment in a capitalist system.9. The Marginal Productivity Approach in GeneralSo far, we have applied the marginal productivity approach toanalyze the demand for labor, in the Neoclassical tradition.However, the marginal productivity corresponds to the demandfor any input. In general, we can define themarginal productivity of any input asthe additional output as a result of adding one unit more unitof that input, with all other inputs held steady.In algebraic terms, that is approximately
that is, the increase in output divided by the correspondingincrease in the input, while the other inputs do not vary.We can then define the value of the marginal product for anyinput asVMPinput=p*MPinput
where p stands for the price of the output, as before. In general,we may think of the VMP as the marginal productivity of theinput in money terms. The rule for maximization of profits,for each input, is to increase the use of the input untilVMPinput=price input
Now let’s apply that to the land input in next lesson.
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LESSON 29:LAND, CAPITAL AND NATURAL RESOURCES
1. The Marginal Productivity Approach inGeneralSo far, we have applied the marginal productivity approach toanalyze the demand for labor, in the Neoclassical tradition.However, the marginal productivity corresponds to the demandfor any input. In general, we can define the marginal produc-tivity of any input as the additional output as a result ofadding one unit more unit of that input, with all other inputsheld steady.In algebraic terms, that is approximately
that is, the increase in output divided by the correspondingincrease in the input, while the other inputs do not vary.We can then define the value of the marginal product for anyinput as
VMPinput=p*MPinput
where p stands for the price of the output, as before. In general,we may think of the VMP as the marginal productivity of theinput in money terms. The rule for maximization of profits,for each input, is to increase the use of the input until
VMPinput=price input
Now let’s apply that to the land input.
2. LandNow, let’s apply the marginal productivity approach to land. Wemay think of a potato farmer who is considering rentingadditional land to farm. How much land? Of course, that willdepend on the rent per acre — the price of land.Using the general formulae for marginal productivity and thevalue of the marginal product from the previous page, we candefine the marginal productivity of land as
that is, the increase in output (measured in bushels of potatos)divided by the corresponding increase in the number of acres ofland used, while the other inputs do not vary.The value of the marginal product of land will beVMPland=p*MPland
where p, again, stands for the price of the output — a bushelof potatos, in this case.Continuing the example of producing potatos, the value of themarginal productivity (in the potato example) is the marketvalue of the additional potatos produced on one additional acre
of land. The farmer will increase the number of acres of land herents untilVMPland=price land
And so the value of the marginal product of land is thedemand curve for land of a standard quality.
3. Differential RentHowever, land is not a homogenous resource, and thatimportant complication cannot be skipped over. It is the basisof the theory of rent, first proposed by English economistDavid Ricardo, and still considered the correct theory of rent byjust about all economists.Some land is more fertile than other kinds of land, or moreprofitable because it is closer to markets; and some land is moresuitable to one kind of crop than another. These differences infertility will be reflected in the marginal productivities andtherefore in the demands for the different kinds of land. Let usthink of a very small economy with just three kinds of land:good, fair, and bad. There are just 10,000 acres of each kind ofland. The supply and demand for each kind of land is shown inFigure 6 below:
Figure 1: Marginal Productivity of Landwith Different Fertilities
The demand for good land is pMPA, for fair land pMPB, and forbad land pMPC. The supply of land of a particular quality isalways a vertical line, because “they’re not making any more ofit” — the supply of land cannot be increased no matter howhigh the price. Since there are 10,000 acres of each sort of land,the three kinds of land have identical supply curves, all shownby the vertical line at S.In a supply-and-demand equilibrium, then, the rent per acre ofgood land will be RA. For fair land it will be RB, and for bad landzero. The bad land in this example is what Ricardo called“marginal” land — good enough to be cultivated, but only if itcan be had free of rent.Thus, the rent on fair land is just enough to offset its greaterproductivity relative to the marginal land. Similarly, the rent on
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good land is just enough to offset its productivity advantageover marginal land. If the rent of good land were any lowerthan that, no-one would want to use fair or marginal land, butall would compete for the limited supply of good land —forcing the rent on the good land up until it is large enough tooffset the productivity advantage of that good land. Similarly,the difference in rent between the good and fair land is justenough to offset the productivity differential between them.This is called the “differential” theory of rent — that the rent ofany land is just large enough to offset its differential productiv-ity relative to marginal land. To stress the basis of land rent, it isoften called differential rent.This idea — that rent is based on differential productivity,which is given by nature and not the result of the landowner’saction — is what led the American social activist, Henry George,to propose that land rent ought to be largely confiscated bytaxation.
4. Natural ResourcesNatural resources include such things as standing forests andschools of fish, deposits of petroleum, copper ore and gold,and similar biological and mineral resources. Traditionally, theseresources are lumped with land in economics. One reason forthis tradition is that the market prices of all natural resourcesinclude an element of differential rent.The case is simplest for such renewable natural resources assecond-growth forests. Essentially, woodland is one crop thatmay be grown on the land, and if the land is best suited forwoodland, its rent will be based on its value in growing timber.The productivity of land in this sort of use will also depend onthe cost of extraction. If the land is very hilly or swampy, thenit may be difficult to use machinery, or more costly machinerymay be needed — raising the cost of harvesting the timber.With natural resources in general, cost of extraction is inverselyrelated to productivity and therefore rent.For mineral resources such as petroleum and gold (and old-growth forests), no renewal is possible in an economicallymeaningful time frame. Nevertheless, the supply-and-demandprice of natural resources will include a component of differen-tial rent. The cost of extraction of mineral resources will vary.For example, petroleum at great depth or under deep water willcost much more to drill and operate the well than shallow, dry-land oil deposits. Thus the shallow, dry-land deposits withlower costs of extraction are more productive. In general thecheaper deposits will be extracted first. But oil or minerals fromcostly deposits must sell for the same as those from depositsthat are cheap to extract, so the ones from deposits with lowcosts of extraction will be sold at over their cost, the differencebeing differential rent.
5. CapitalThe third of the classical “factors of production” is capital. Theearliest generation of economists did not think of capital asbeing an independent factor. But as the nineteenth century woreon, it was increasingly clear that capital (and specifically, mechani-zation) is a key factor in modern production. It was NassauSenior who pointed out that capital investment in and of itselfwould increase productivity. Senior wrote “That the powers of
Labor, and of the other instruments that produce wealth, maybe indefinitely increased by using their Products as the means offurther production.”As we know, capital is more than just machinery, but it may behelpful to think in terms of a specific kind of machine. We maythink of a tractor to be used on the potato farm. As we increasethe number of machines in use, with the same amount of landand labor, output will increase, but at a decreasing rate. Capital,like the other inputs, is subject to diminishing returns.Onceagain, we will focus on the “marginal productivity” of themachines. On the other hand, the costs of using the machinerywill also increase as the number of machines increases.The machines will gradually wear out and will have to bereplaced.It is customary to deduct wear and tear from the output, so thatthe total and marginal productivity are net of wear and tear.But, for practical applications, we should remember that wearand tear is a real cost and must be taken into account.The resources “tied up” in the machine have an opportunitycost.The money laid out to buy the machines pays for the resourcesused in producing the machines. The money (and resources)will be recovered only gradually, using the machines to producegoods and services. However the money (and the resources)could be used for other purposes. For example, the investormight instead have bought a vineyard, which would produce acrop of wine grapes every year. It will not make sense to investin the machine unless the net revenue from using the machineto produce goods and services is worth at least as much as thewine grapes. Similarly, the investor might instead have leant hismoney to someone else, to finance either production orconsumption expenditures. It will not make sense to invest inthe machine unless the net revenue from using the machine toproduce goods and services is worth at least as much as theinterest the investor could get on the loan.Of course, capital includes many kinds of producers’ goods,from tractors and other machines through grapevines andorchards and many intangible assets. What they all have incommon is the opportunity cost corresponding to the interestrate. With that in mind, we identify the price of capital as theinterest rate. The demand for capital is the marginal productivityof capital (net of wear and tear) times the price of output.As for the supply of capital, that will depend on the decisionsmade by savers. Many economists believe that an increase ininterest rates will result in an increase in saving and so in thequantity of capital supplied, giving an upward sloping supplycurve of capital. However, for capital as for labor, it is logicallypossible that the supply curve (in the economy as a whole)could be backward sloping. For an individual industry, however,the supply of capital will probably be horizontal and corre-spond to the opportunity cost of capital in other industries.In the next page, we see a picture of the supply and demand forcapital as many economists understand them.
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6. Demand for CapitalHere is a diagram the demand for capital by an individual firmas it is sketched in the previous page. We assume that the firmuses a given quantity of labor and land and that the quantity ofcapital used varies. The quantity of capital used (measured indollars’ worth) is marked off on the horizontal axis. On thevertical axis is the rate of interest, which we understand as theprice of capital.
Figure 2: Marginal Net Productivity asthe Demand for Capital
In the diagram, the horizontal red line, corresponding to themarket interest rate, is the supply curve of capital to the firm.The green line is the demand for capital, that is, the marginalproductivity of capital (net of the cost of wear and tear ofspecific capital goods) times the price of the output — the valueof the marginal product of capital. The profit-maximizingdemand for capital for the firm is shown by K. That is, it will beprofitable to expand the capital stock of the company untildiminishing returns reduces the value of the marginal productto r, the market rate of interest, at K.Some economists criticize this approach to the supply anddemand for capital on the grounds that “capital” really consistsof many different kinds of capital goods and cannot beexpressed as a single amount of “capital.” If we accept thatargument, we would have to think of a marginal productivitycurve and demand for each respective capital good, measure thecapital goods in natural units (number of machines, number ofgrapevines, and so on), and treat the price in a little morecomplicated way. But, for microeconomics, the results would bepretty much the same: the demand for a capital good, like thedemand for any input, depends on marginal productivity.Now let’s look at an important application of the marginalproductivity approach in the economics of factors of produc-tion.
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LESSON 30:INCOME AND WEALTH
1. Income Distribution and Labor Demand
As we observed in previous lessons, the marginal productivityapproach originated with John Bates Clark. Clark was especiallyconcerned with the division of income between labor andproperty, and the John Bates Clark model provides us with avisualization of income distribution. Let’s look at that in a littlemore detail.We will use the marginal productivity approach to the demandfor labor as the basis of our discussion. Here is another look atthe key picture.
Figure 1: Wages and ProfitNotice the shaded area between the VMP curve and the price(wage) line. Remember, the area of the shaded triangle is thetotal amount of payments for profits, interest, and rent — inother words, everything the firm pays out for factors ofproduction other than labor. We have seen that the demand forland and capital can be visualized in quite different ways, butthere is no conflict there — the same thing can look differentwhen we look at it from different points of view. When wewant to visualize the demand for land or for capital individu-ally, then we will use marginal productivity diagrams as we didin the last few pages. But it is equally correct to think of thepayments to land and capital as what is left over after the wagebill has been paid. That’s the point of view we will take in therest of this chapter.
2. The Labor Market and the Distribution of Income
In the idealized market society that John Bates Clark envi-sioned, the wage is determined by the supply and demand forlabor. The demand for labor is the Value of the MarginalProduct of labor in the society as a whole. The supply of laboris determined by the population and the preferences ofworkers with respect to more income and consumption versusmore holidays and shorter work hours. Here is a picture toillustrate the idea:
Figure 2: Division of Income Between Work and PropertyThe equilibrium is shown by the orange lines: the equilibriumwage is $500 per labor week, as in our earlier examples, and theequilibrium quantity of labor hired is something less than 500units of labor. The total income of the workers is shown bythe rectangular area shaded light green, and the total income toproprietors is the triangular area shaded light pink.
3. Functional and Personal Distribution
This John Bates Clark theory of the distribution of incomeillustrates what economists call the “functional distribution ofincome.” Economists distinguish two concepts of the distribu-tion of income:The functional distribution of incomeThe functional distribution of income is the distributionbetween groups in society who own different factors ofproduction, i.e. the proportion of income going to employees,landowners, and owners of capital respectively.The personal distribution of incomeThe personal distribution of income is the distribution ofincome among individuals, families or households, regardlessof what factors of production they own.Of course, the personal distribution depends partly on thefunctional distribution, but it also depends on who owns what.In other words, the words of British radical economist JoanRobinson, the functional distribution tells us the distributionof income among the factors of production, but the personaldistribution depends on the distribution of the “factors amongthe chaps.”This is important if we are concerned about inequality in thedistribution of income. Generally, income from land and capitalis much less equally distributed than income from labor. In theidealized John Bates Clark world, income from labor would beabsolutely equally distributed among those who work the samehours, because labor is assumed to be homogenous. But that’sa simplifying assumption. In the real world, people who havebetter skills or stronger bodies may be able to earn a higherwage. This makes for some inequality in labor income. But theownership of land and capital is much more unequally distrib-
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uted than the capacity to earn wages, so income from property ismuch more unequally distributed among persons.
4. Just Distribution of Income
Thus, the John Bates Clark model provides us with a theoryabout “what is” the functional distribution of incomebetween labor and property-owners. Clark went still further andclaimed that this distribution would be just.Of course, justice is a matter of normative economics, notpositive economics, since saying that something is just impliesthat “it ought to be.” How could Clark claim that paymentaccording to the marginal product is just? Clark was applying avalue judgment that it is just to pay people according to whatthey contribute to the product of society. He claimed that themarginal product of labor is the appropriate measure of whatthe individual worker contributes, so it would be just that theworker be paid her or his value marginal product. The rent,interest, and profits, incomes to property owners, wouldcorrespond to the marginal product of the land and capital,according to Clark, so their payment would also be just.But, of course, this is controversial. Not everyone would acceptthe idea that people ought to be paid according to theircontribution. The Reasonable Dialog perspective is especiallyimportant here. We can easily make two opposite mistakes: first,to suppose that this value judgment is obviously true — if weagree with it in the first place! — or that it is a matter ofarbitrary opinion, without any basis in reason at all. Here aresome criticisms of the value judgment that “it is just to paypeople according to what they contribute to the product ofsociety:”What people contribute depends on the opportunities theyhave to contribute. For example, if a person cannot find a job,despite his best attempts, his failure to contribute to society isunavoidable, and it is unjust that he be deprived of an incomeon that account.Clark would probably respond that in the competitive society heenvisioned this would be impossible, since all obstacles tofinding employment would be removed. The idea behind thesupply and demand model is that everyone who is willing tosupply labor finds a matching demand — at the equilibriumwage.What people contribute to production is mostly a result offactors they themselves had nothing to do with. For example,very few of us could contribute anything much without relyingon the methods, technology and experience we have taken fromthe generations that preceded us. Some of our output may alsobe the result of gifts of nature (or of God) that we arefortunate to have. Why should we be rewarded for being luckyenough to have access to these resources of natural gifts andtechnology and historic experience?I’m not sure how Clark would respond to this one. He wouldprobably say that natural gifts really don’t differ very much, andthat in any case the resources of natural gifts and technologyand experience wouldn’t produce anything if they were notpropelled by human effort, so that the product really isproportionate to the effort, and that effort should be rewarded.
Just what is a contribution? Followers of the American activistHenry George, for example, say that land is not a contributionon the part of the landowner, since land is a free gift of nature.Marxists and other labor radicals would go even further, sayingthat only work is a contribution to the social product, so thatworkers are entitled (individually or as a group) to 100% of theproduct.Clark would probably dismiss this as a confusion, saying thatthe Marxist misses the point of marginal analysis. But thatresponse could be hasty. The real difference seems to be in thedefinition of terms: what really counts as a “contribution?”Another unspoken assumption in the John Bates Clark versionof normative economics is that the distribution of property isjust. No-one would say that it is just for a thief to be paid forcontributing the property he has stolen. Income to property-owners cannot be just unless the owner has a just claim to ownthe property. Not everyone would agree that capitalist propertyownership is just. Marxists say that all capitalist propertyoriginates from exploitation, or from actual plunder, so theywould say the distribution and ownership of property in acapitalist market system is itself not just, so no distribution ofincome to property could be just. Clark’s model doesn’t addressthis question.So there is plenty of room for controversy about the normativeeconomics of income distribution. But even if we do not agreewith it, we must recognize Clark’s contribution of a precise andlogically constructed account of one view in normative econom-ics. Because of its precision and clarity, it lends itself to moreconstructive discussion, both from a critical and supportivepoint of view.However, we will not be able to explore the controversy muchfurther in our book, but instead will return to positive econom-ics — the description and explanation of what is. As we haveseen, the John Bates Clark theory is mostly a theory of thefunctional distribution of income, while normative economicsis also concerned with the personal distribution of income.Let’s look a little more carefully at equality and inequality in thepersonal distribution of income.
5. Visualizing the Personal Distribution of Income
We can visualize the personal distribution of income using agraphic presentation called the Lorenz curve. Here is a Lorenzcurve for the American economy in 1994.
Figure 3 Lorenz Curve
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The Lorenz curve is the dark red curve in Figure 8 above. Onthe horizontal axis we have the proportion of the population,and on the vertical axis we have the proportion of total incomeearned by the corresponding fraction of the population. Thus,the figure tells us that the poorest 20% of the populationearned only 3.6% of the income, the poorest 40% of thepopulation earned 12.5 percent of income, and so on. similarly,the least well off 95% of the population earned 78.8% of theincome, leaving 21.2% for the richest 5% of income for therichest 5%.If income were distributed with perfect equality, then thepoorest 20% of the population would earn exactly 20% ofincome, the poorest 40% of the population would earn 40%of income, and the richest 5% of the population would earnexactly 5% of income. As a result, the Lorenz curve for an equaldistribution would be a forty-five degree diagonal line, shownby the green line in Figure 8. The curvature of the Lorenz curve,as it droops below the 45 degree line, shows the inequality ofthe income distribution.The data for these examples were supplied by the censusbureau.
6. Measuring Inequality in Income Distribution
The Lorenz Curve construction also gives us a rough measureof the amount of inequality in the income distribution. Themeasure is called the Gini Coefficient. Computation of theGini Coefficient is illustrated by Figure 4below.
Figure 4. Lorenz Curve and Gini CoefficientTo compute the Gini Coefficient, we first measure the areabetween the Lorenz Curve and the 45 degree equality line. Thisarea is divided by the entire area below the 45 degree line (whichis always exactly one half). The quotient is the Gini coefficient, ameasure of inequality. In other words, the Gini coefficient is thearea shaded in pink divided by the total of the areas shaded inpink and light blue-green.For a perfectly equal distribution, there would be no areabetween the 45 degree line and the Lorenz curve — a Ginicoefficient of zero. For complete inequality, in which only oneperson has any income (if that were possible) the Lorenz curvewould coincide with the straight lines at the lower and right
boundaries of the curve, so the Gini coefficient would be one.Real economies have some, but not complete inequality, so theGini coefficients for real economic systems are between zero andone.The Gini coefficient for the United States in 1994 (according tothe Census Bureau) was 0.456.
7. Changing Income Inequality
Income inequality in the United States has increased in recentdecades, and this has recently become a concern to someeconomists and others interested in economic and politicalissues. Lorenz curves for the United States are shown in Figure5 below.
Figure 5. Lorenz Curves of the United StatesThe four Lorenz curves are for 1970, 1980, 1990, and 1994, andare color-coded as follows:
Table 1years 1970 1980 1990 1994colors black green blue redGiniCoefficients 0.394 0.403 0.428 0.456
We observe a steady, and perhaps accelerating, tendency towardincreased inequality over this period. This can also be observedwhen we look at the Gini Coefficients for the four years, shownin the third row of the table. We see that the over-all increase isabout sixteen percent, or one-sixth.
8. Explaining the Changes
How are we to explain these changes in terms of the functionaldistribution of income? There are at least three possibleexplanations:• The distribution of wage income may have become more
unequal.• The distribution of income from property may have become
more unequal.• The functional distribution may have shifted, so that
property incomes are a larger fraction of total incomes.The last one, a shift of the functional income distribution sothat property income is a larger fraction of the total, wouldmake the personal distribution of income more unequalbecause property incomes are the more unequal component.
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Increasing the weight on the more unequal component willincrease overall inequality.When we look at the record in detail, it seems that both the firstand the last of the three things seems to have happened. Wehave to distinguish between the markets for unskilled andskilled labor. This is a little more complex that the John BatesClark model, which thinks in terms of homogenous labor, butthe same principles can be applied without much difficulty. Oneexplanation that fits the facts pretty well is that there has been abig decrease in the demand for unskilled labor. It’s easy to seehow that would cause an increase in the inequality of wageincome. Unskilled workers were already being paid less, then adrop in the demand for their labor depresses their wages, andthey make even less, relative to skilled labor. The John BatesClark model helps out by showing us how this would also tendto shift the functional distribution of income.Take a look at Figure 6:
Figure 6: A Decrease in the Demand for Unskilled LaborThe demand for unskilled labor is, again, the value of themarginal product. Before the decrease in demand, the supplyand demand for unskilled labor are S1 and D1, and the marketwage is c. The unskilled workers earn an amount visualized bythe rectangle cbd0, and profits on their work amount to thetriangle abc. Now there is a big decrease in the demand forunsilled labor, to D2, partially offset by a slight decrease in thesupply, to S2. The new wage for unskilled labor is h, much lowerthan before, as we anticipated. Now, in addition, unsilledworkers are earning a much smaller share — hkg0 by compari-son with profits akh. Since the share of unskilled workers isless, if nothing has changed the share of skilled workers, theoverall share of labor in the functional distribution of incomewill have declined.
9. The Functional Distribution, Again
We can check that explanation against the facts. Did the shares inincome in fact shift away from labor in the last 25 years?It seems that they did. Here are some data on labor incomesand property incomes. Labor incomes include all wages andother labor compensation, while property incomes include
interest, rent, and dividends, as reported by the census bureau.The incomes are before taxes and do not include governmentsubsidies, either. The following table shows the fraction of thetotal labor and property incomes that were labor incomes, in thesecond row, and property incomes in the third row. the fourthrow shows the breakdown between labor and property incomesas a “pie chart.”
Table 2
year 1970 1980 1990 1994 labor incomes 0.86 0.83 0.80 0.82
property incomes 0.14 0.17 0.20 0.18
In the “pie charts,” of course, the labor share is represented bythe blue shaded “pie” and the share of property income by thepinkish shaded “piece of the pie.” We see the share of propertyincome getting consistently larger through the first two periods.That’s consistent with the explanation that greater inequality is aresult of a shift of the functional distribution of incometoward a greater proportion of property incomes. In 1994,however, we see a slight shift back toward a larger share forlabor incomes, although the inequality continued to increasefrom 1990 to 1994. It would seem that other factors becamemore important in the four years 1990-1994.What the evidence suggests is that shifts in both the functionaldistribution of income and the inequality of wages are factorsin the increase in inequality since 1970. In general, we will findthe John Bates Clark model is a good starting point, but onlygives us part of the story.
10. Chapter SummaryIn this chapter we have explored the supply and demand forfactors of production, land, labor, and capital. The discussioncomplements our discussions in Chapter 3 of the supply anddemand for consumer products. The basic ideas for thisdiscussion are the marginal productivity of the input and the“value of the marginal product,” that is, marginal productivitytimes the price.• We began with a discussion of the supply and demand for
labor.• The demand for labor is identified with the value of the
marginal product” of labor.• The supply of labor depends on the population and on
its preferences between earning more income andenjoying more leisure.
• The price of labor is the wage, and we see an equilibriumif the wage is just high enough so that the quantity oflabor demanded is equal to the quantity supplied.
• This leads to an application to minimum wageregulations — and the conclusion that such regulationsare likely to put some employees out of work.
• Some economists doubt that the supply-and-demandapproach really works in labor markets, and proposealternative approaches. But in many cases the alternative
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approaches incorporate marginal productivity along withother influences on wages and employment.
• We next discussed the supply and demand for land andnatural resources.• Here again, demand is identified with the value of the
marginal product.• The supply, however, is given by nature.• But different parcels of land have different fertility, so
that demanders have to pay “differential rent.”• The supply and demand for capital were next discussed.
• We think of the interest rate as the price of capital.• The demand is again identified with the value of the
marginal product of capital.
We then applied the marginal productivity approach to explainthe distribution of income and its trends in recent years. Themarginal productivity approach gives us a theory of thefunctional distribution of income, which is one aspect of thedistribution among persons. We find that the recent trends inincome distribution do “make sense” when we apply themarginal productivity approach to them. But is that the onlyexplanation? The criticisms of markets for labor can be appliedalso to the marginal productivity approach as a whole, and tothis application, so there may be other aspects, or even acompletely different approach, that will make better sense.However, we have come to the limit of what this book can sayabout the marginal productivity approach and the alternatives toit. Students who are interested in alternative approaches, or adeeper discussion of this approach, will find it in moreadvanced textbooks
Factor Markets
Factor of Production
? used to produce some output.
? also called an input or a productive resource.
? examples: labor, machinery, raw materials, land
Factor Market
? a market for a factor of production.
? example: The market for construction workers brings together the buyers and sellers of construction workers’ services.
The demand for an input is derived from the demand for the output that the input helps produce.
Derived Demand
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Note
A firm might be a perfect competitor in the product market and might not be a perfect competitor in the factor market, or vice versa.
Four Possibilities for a Firm
? Perfect competitor in the product market, and perfect competitor in the factor market.
? Perfect competitor in the product market, but not a perfect competitor in the factor market.
? Not a perfect competitor in the product market, but a perfect competitor in the factor market.
? Not a perfect competitor in the product market, and not a perfect competitor in the factor market.
Example: The local water company is the onlywater company in the area. It is one of manyemployers who hire accountants.
Example: The local water company is the onlywater company in the area. It is one of many employers who hire accountants.
This firm is not a perfect competitor in the product market (water market).
Example: The local water company is the only water company in the area. It is one of manyemployers who hire accountants.
This firm is not a perfect competitor in the product market (water market).
It may be a perfect competitor inthe factor market (market for accountants).
Example: A small mill town is owned by a textile company. The company is the only employer in town.
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Example: A small mill town is owned by a textile company. The company is the only employer in town.
This firm may be a perfect competitorin the product market (textile market).
Example: A small mill town is owned by a textile company. The company is the only employer in town.
This firm may be a perfect competitorin the product market (textile market).
It is not a perfect competitorin the factor market (labormarket).
Price -Taking in the Factor Market
Just as a firm in a perfectly competitive product market takes the price of the product as given, a firm in a perfectly competitive factor market takes the price of the factor as given.
The firm can hire as much of the input as it wants at the going input price.
So, the supply curve of the input to the firm is a horizontal line at the input price.
The Supply Curve of Labor to a Firm that is a Perfect Competitor in the Labor Market
price of labor
labor
PLS
Factor Market Terms
Marginal Resource Cost (MRC)
the change in total cost that results from the employment of an additional unit of an input.
MRC = ? TC / ? L
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Marginal Physical Product (MPP) or Marginal Product (MP)
the change in the quantity of output that results from the employment of an additional unit of an input.
MPP = ? Q / ? L
Marginal Revenue Product (MRP)
the change in total revenue that results from the employment of an additional unit of an input.
MRP = ? TR / ? L
What is the difference between the MPP and MRP?
Suppose your company produces chairs.
The MPP tells how many more chairs you can make if you hire another worker.
The MRP tells how much more revenue you can make from the additional chairs produced by the additional worker
Alternative formula for MRP
MRP = ? TR = ? TR ? Q? L ? L ? Q
= ? TR ? Q ? Q ? L
= MR . MPP
So, MRP = MR . MPP
Value of the Marginal Product (VMP)
the price of the output multiplied by the marginal physical product of the input.
VMP = P . MPP
Sometimes MRP = VMP, but not always.
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Recall: If a firm is a perfect competitor in the product market, marginal revenue is equal to the price of the output (MR = P).
Then, MRP = MR . MPP
= P . MPP
= VMP
So, MRP = VMP
for a firm that is a perfect competitor in theproduct market.
Recall: If a firm is a not perfect competitor in the product market, marginal revenue is less than the price of the output (MR < P).
Since MRP = MR . MPP
and VMP = P . MPP,
MRP < VMP,
for a firm that is not a perfect competitor in the product market.
If a firm is perfectly competitive in the product market, then MRP = VMP.
If a firm is not perfectly competitive in the product market, then MRP < VMP.
Example: A firm sells its shirts in a perfectly competitive productmarket for $10 each.
L Q
0 0
10 70
20 130
30 180
40 220
50 250
60 270
70 280
Example: A firm sells its shirts in a perfectly competitive productmarket for $10 each.
L Q MPP=? Q/? L
0 0 ---
10 70 7
20 130 6
30 180 5
40 220 4
50 250 3
60 270 2
70 280 1
Example: A firm sells its shirts in a perfectly competitive productmarket for $10 each.
L Q MPP=? Q/? L TR=PQ
0 0 --- 0
10 70 7 700
20 130 6 1300
30 180 5 1800
40 220 4 2200
50 250 3 2500
60 270 2 2700
70 280 1 2800
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Example: A firm sells its shirts in a perfectly competitive productmarket for $10 each.
L Q MPP=? Q/? L TR=PQ MR =? TR/ ? Q
0 0 --- 0 ---
10 70 7 700 10
20 130 6 1300 10
30 180 5 1800 10
40 220 4 2200 10
50 250 3 2500 10
60 270 2 2700 10
70 280 1 2800 10
Example: A firm sells its shirts in a perfectly competitive productmarket for $10 each.
MRP = ? TR/? LL Q MPP=? Q/? L TR=PQ MR =? TR/ ? Q MRP= MR. MPP
0 0 --- 0 --- ---
10 70 7 700 10 70
20 130 6 1300 10 60
30 180 5 1800 10 50
40 220 4 2200 10 40
50 250 3 2500 10 30
60 270 2 2700 10 20
70 280 1 2800 10 10
Focusing on the first and last columns of the previous table, we have the MRP schedule.
L MRP
0 ---
10 70
20 60
30 50
40 40
50 30
60 20
70 10
Plotting points we have a graph of the MRP curve.
MRP
labor0 10 20 30 40 50 60 70
70605040302010
MRP
MRP > MRC employ more input
MRP < MRC cut back employment
MRP = MRC profit -maximizingemployment level
When should you employ moreof an input?
profit -maximizing condition for input usage:
MRP = MRC
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MRC in a Perfectly Competitive Labor Market
Each time a firm hires another unit of labor, its cost increases by the price of the labor (P L).
So for a firm in a perfectly competitive labor market, MRC = P L .
(If a firm is not in a perfectly competitive labor market, this is not true.)
Suppose the firm in the example we considered earlier is also perfectly competitive in the labor market.
So the MRC is the same as the price of labor or the market wage. Let’s see what the demand curve for labor is for this firm. What we need to know is how many workers will be hired at various wage levels.
Remember: You hire workers as long as they add at least as much to revenues as to cost.
Suppose the market wage is $70. How many workers will you hire?
10Suppose the market wage is $60. How many
workers will you hire?20
Suppose the market wage is $50. How many workers will you hire?
30Suppose the market wage is $40. How many
workers will you hire?40
L MRP0 ---
10 70
20 60
30 50
40 40
50 30
60 20
70 10
Remember we have been trying to determine what the demand curve for labor looks likefor this firm.
All of our demand curve points have been points on the MRP curve.
The demand curve for labor by the firm is just (the downward sloping part of) the MRP curve.
A Firm’s Demand Curve for Labor
$
labor0 10 20 30 40 50 60 70
70605040302010
demand curve for labor
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TUTORIAL 7
1. Case Study
The New Workforce
Lead Story-dateline: The Economist, August 25-31, 2001.
Of all the big developed countries, America now has thesmallest proportion of factory workers in its labor force. BeforeWorld War I, there was not even a word for people who madetheir living other than by manual work. The term “serviceworker” was coined around 1920, but it has turned out to berather misleading. These days, fewer than half of all non-manual workers are service workers. The only fast-growinggroup in the workforce in America, and in every other devel-oped country, are “knowledge workers” and “knowledgetechnologists” - people whose jobs require formal and advancedschooling. They now account for a full third of the Americanworkforce, outnumbering factory workers by two to one. Inanother 20 years or so, they are likely to make up close to two-fifths of the workforce of all rich countries. The term“knowledge industries,” “knowledge work,” and “knowledgeworker” are only 40 years old, coined around 1960. Knowledgeworkers, collectively, are the new capitalists who own the meansof production, and through their stakes in pension funds andmutual funds, they have become majority shareholders andowners of many large businesses in the knowledge society, and,therefore, are capitalists in the old sense of the word. Knowl-
edge workers see themselves as equal to those who retain theirservices: as “professionals” rather than as “employees.” Theknowledge society is a society of seniors and juniors rather thanof bosses and subordinates.
Thinking About the Future!The upward mobility of the knowledge society comes with thepsychological pressures and emotional traumas of the rat race.These pressures create hostility to learning. America, Britain,Japan, and France are allowing their schools to become viciouslycompetitive. The fact that this has happened over such a shorttime - 30 to 40 years - indicates how much the fear of failure hasalready permeated the knowledge society. Given this competitivestruggle, successful knowledge workers “plateau” in their 40s.Knowledge workers, therefore, need to offset this by develop-ing an alternative non-competitive life and community of theirown for personal contributions and achievement.
Talking It Over And Thinking It Through!
1. What are the implications of the shift toward knowledgeworkers for the role of women in the labor force?
2. What is the difference between knowledge workers andknowledge technologists?
3. How does knowledge compare with traditional skills andmeans of production?
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ESSENTIAL PRINCIPLES
What are the Essential Principles ofEconomics?Here are the Essential Principles of Economics I have tried toexplain, illustrate and apply in this book. There are ten majorprinciples. That’s a nice round number. But I have kept thenumber of main principles small mainly by putting some prettyimportant topics among the 25 to 35 subordinate topics(depending on how you count). Links are given, but some ofthe linked pages may be hard to understand out of context.
Division of LaborI put the division of labor first mainly because Adam Smithdid, arguing that division of labor is the key cause of improv-ing standards of living. Modern economics doesn’t do muchwith the concept of division of labor, but two closely relatedconcepts are important:
Returns to ScaleReturns to scale may be increasing, constant or decreasing.Increasing returns to scale is the case that leads to special results,and division of labor is one cause (arguably the main cause) ofincreasing returns to scale.
Virtuous Circles in Economic GrowthFor Smith, a major consequence of division of labor andresulting increasing productivity was a “virtuous circle” ofcontinuing growth. Modern “virtuous circle” theories havemore dimensions, but division of labor and (resulting?)increasing returns to scale are among them.
Opportunity CostThe idea is that anything you must give up in order to carry outa particular decision is a cost of that decision. This concept isapplied again and again throughout modern economics. If(God forbid) you were to learn only one of the Principles ofEconomics thoroughly, this should be the one.
ScarcityAccording to modern economics, scarcity exists whenever thereis an opportunity cost, that is, where-ever a meaningful choicehas to be made.
Production Possibility FrontierThe production possibility frontier is the diagrammaticrepresentation of scarcity in production.
Comparative AdvantageA very important principle in itself, and a key to understandingof international trade the principle of comparative advantage isat the same time an application of the opportunity costprinciple to trade.
Discounting of Investment ReturnsAnother application of the opportunity cost principle that isvery important in itself, this one tells us how to handleopportunities that come at different times.
The Equimarginal PrincipleThis is the diagnostic principle for economic efficiency. It haswide applications in modern economics. Two of the mostimportant are key principles of economics in themselves:
The Fundamental Principle of MicroeconomicsThis principle describes the circumstances under which marketoutcomes are efficient, and
The Externality Principledescribes some important circumstances in which they are not.Of course, the equimarginal principle is founded on
Marginal AnalysisAlso an important principle in itself and very widely applied inmodern economics. There is no major topic in microeconomics(I believe) that does not apply marginal analysis and opportu-nity cost. The link shown above is the marginal analysis ofproductivity, but marginal analysis also has applications to cost,revenue, consumers’ utility and benefits, and more.
Market EquilibriumThe market equilibrium model could be broken down intoseveral principles — the definitions of supply, demand,quantity supplied and demanded and equilibrium, at least —but these all complement one another so strongly that there isnot much profit in taking them separately. However, there aremany applications and at least four important subsidiaryprinciples:
Elasticity and RevenueThese ideas are a key to understanding how market changestransform society.
The Entry PrincipleThis tells us that, when entry into a field of activity is free,profits (beyond opportunity costs) will be eliminated byincreasing competition. This has a somewhat different signifi-cance depending on whether competition is “perfect” ormonopolistic.
Cobweb AdjustmentThis might give the explanations when the market does notmove smoothly to equilibrium, but overshoots.
Competition vs. MonopolyWhy economists tend to think highly of competition, andlowly of monopoly.
Diminishing ReturnsPerhaps the best-known of major economic principles, thePrinciple of Diminishing Returns is much more reliable inshort-run than in long-run applications, so the Long Run/Short Run dichotomy is an important subsidiary principle.Modern economists think of diminishing returns mainly inmarginal terms, so marginal analysis and the equimarginalprinciple are closely associated.
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Game EquilibriaGame theory allows strategy to be part of the story. One resultis that we have to allow for several kinds of equilibria. We have• Noncooperative equilibrium
• Prisoners’ Dilemma (dominant strategy) equilibria whichare
• Nash (best response) equilibria, (but not all Nashequilibria are dominant strategy equilibria), and
• Cooperative equilibriaAnd that’s just the beginning. The main applications in thisbook, and traditionally, are in the study of
• oligopoly.
Measurement Principles
Economics is multidimensional, and that creates somedifficulties in measuring things like production, incomes, andprice levels. Some of the problems can be solved more or lessfully.
Value Added and Double CountingOne for which we have a pretty complete solution is theproblem of double counting: the solution is, use value added.
“Real” Values and Index NumbersSince we measure production and related quantities in dollarterms, we have to correct for inflation. Index numbers are apretty good workable solution, but there are some problemsand criticisms.
Measurement of InequalityAnother issue is that the “average income” may not mean verymuch, because nobody is average and income is unequallydistributed. Even if we cannot correct for that (what would thatmean?) we can get a rough measure of the relative inequalityand see where it is going.
Medium of ExchangeMoney is whatever is generally acceptable as a medium ofexchange. That means a bank, or similar institution, can literallycreate money, so long as people trust the bank enough to acceptits paper as a medium of exchange. We might call this magicalfact the Fiduciary Principle.
Income-Expenditure EquilibriumLike the market equilibrium principle, but even moreso, thismodel pulls together a number of subsidiary principles thatcomplement one another and together constitute the“Keynesian” theory of aggregate demand. The implications ofthis theory are less controversial than the word “Keynesian” is— controversy has to do more with the details than theapplications. Among the subsidiary principles are• Coordination Failure• The income-consumption relationship• The Multiplier• Unplanned inventory investment• Fiscal Policy• The Marginal Efficiency of Investment• The influence of money on interest
• Real Money Balances• Monetary Policy
The Surprise PrinciplePeople respond differently to the same stimuli if the stimulicome as a surprise than they would if the stimuli do not comeas a surprise. This new economic principle plays the key rolewith respect to aggregate supply that “Income-ExpenditureEquilibrium” plays with respect to aggregate demand.
Rational ExpectationsPeople don’t want too many unpleasant surprises. If they usethe information available to them efficiently, then they won’t besurprised in the same way very often. This can lead to
Policy IneffectivenessBut it is hard to reconcile this way of thinking with the apparent
Permanenceof many economic changes, especially those in unemployment.These suggest that the economy has a high degree of
Path Dependence,and that would put the independence of aggregate supply intosome doubt.
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GLOSSARY
Glossary For Microeconomic ChaptersAdjustment process Path by which a system moves from aposition of isequilibrium to one of equilibrium.Adverse selection A problem in insurance markets caused byasymmetric information. Insurance tends to be purchased mostby those who know that they are high risks.Aggregation A method of simplifying theory by combiningmany markets into a large, composite market.Allocation The determination of what goods and services willbe produced from available resources. Allocation can be donewith markets or with hierarchy.Antitrust policy Policy that makes companies act in a competi-tive manner by breaking up companies that are monopolies,prohibiting mergers that would increase market power, andfinding and fining companies that collude to establish higherprices.Arbitrage Simultaneously buying in a cheap market and sellingin an expensive one.Budget Constraint A line that separates outcomes that areaffordable from outcomes that are not affordable. Occasionallycalled a consumption-possibilities frontier.Change in demand A shift in the demand curve.Change in quantity demanded A change in the amountpeople buy because a change in price moves them along astationary demand curve.Change in quantity supplied A change in the amount sellerssell because a change in price moves them along a stationarysupply curve.Change in supply A shift in the supply curve.Circular flow model A simplified picture of a marketeconomy showing the flow of products from businesses tohouseholds and the flow of resources from households tobusinesses.Consumer Sovereignty In a market economy, it is ultimatelythe wants of the consumers, not the preferences of theproducers, that determine what goods and services are pro-duced.Consumers’ surplus The difference between the maximum abuyer would pay and the actual price.Consumption-possibilities frontier See budget constraint.Contingent behavior Behavior that exists when each person’sactions depend on what he expects others to do.Cross-price elasticity (cross-elasticity) A measure ofwhether goods are substitutes or complements.Demand curve The relationship between price and theamount of a product people want to buy.
Derived demand The demand for a resource depends on, or isderived from, the demand for the things that the resouce helpsproduce.Disequilibrium A condition that exists when a system is notat rest and has a tendency to change.Dollar voting An explanation of how a market economydetermines what goods are produced, made with an analogy tothe political process of voting.Duopoly A market in which there are two sellers.Economic efficiency A situation in which value is maximized.Given resources, technology, and preferences, no changes willincrease value. Also called Pareto optimality.Economic inefficiency A situation in which there is potentialvalue that no one captures. Given resources, technology, andpreferences, there is some change which will improve the well-being on one individual without harming anyone else.Economic Rent See producer surplus.Elasticity A measure of responsiveness.Entrepreneur An individual who creates new a new organiza-tion, market, or product, usually in the quest for profit.Entrepreneurs are innovators.Equilibrium A condition that exists when a system is at restand has no further tendency to change.Externality A cost or benefit that a decision maker passes onto a third party. Pollution is an example of a negative externality.Excise tax A sales tax on a specific item.Fixed cost Cost that does not change as output changes.Free rider Person who does not pay for good or servicebecause there is no way to exclude those who do not pay fromusing the good or service.Game theory An analysis of interactions in which the outcomea person faces depends not only on his strategy of action, butalso on the strategies of others.Human capital Peopleís assets in the form of investment inthemselves.Income elasticity of demand A measure of the responsive-ness of people’s purchases to changes in income.Indifference curve In a graphical representation of a utilityfunction; an indifference curve plots all combinations of goodsand services which provide the same utility. Occasionally calledan isoutility curve.Inferior good A good that people buy less frequently if theirincomes rise.Invisible hand A phrase that expresses the belief that the bestinterests of a society can be served when individual consumersand producers compete to achieve their own private interests.
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Isoquant In a graphical representation of a productionfunction, an isoutility curve shows all ways of producing aspecificlevel of output.Law of demand The principle that there is an inverse relation-ship between the price of a good and the quantity that buyersare willing to purchase.Law of diminishing returns Adding more of one inputwhile holding other inputs constant eventually results in smallerand smaller increases in added output.Lorenz Curve A graphical way to illustrate the equality orinequality of the distribution of income.Marginal cost The change in total cost caused by a one-unitchange in an activity, or the slope of the total cost curve. In thecase of a business, the change in total cost is caused by a changein output.Marginal rate of substitution The ratio at which people willtrade good B for good A.Marginal rate of transformation Slope of the production-possibilities frontier, which shows how much of good B mustbe given up to produce more of good A.Marginal resource cost The change in total cost caused by aone-unit change in an input.Marginal revenue The change in total revenue resulting froma change in sales; the slope of the total cost curve.Marginal revenue product The change in total revenueresulting from a one-unit change in an input.Market failure A situation in which a market yields a resultthat is economically inefficient, that is, there is value that is notcaptured.Maximization principle The rule that net benefits aremaximized when marginal benefit equals marginal cost.Monopoly An industry with only one seller.Monopolistic competition An industry that has easy entryand exit, but in which sellers are price searchers.Monopsony A market with only one buyer.Moral hazard An insurance problem; when the cost of adisaster is reduced with insurance, people have less incentive toavoid the disaster.Negative-sum game In terms of game theory, an interactionin which losses exceed winnings.Normative analysis An analysis based on a judgement aboutwhat is desirable and what is undesirable.Oligopoly An industry in which there are few sellers.Paradox of Value The puzzle of why essential items such aswater are cheap while frivolous items such as diamonds areexpensive. The paradox is easily resolved when one understandsthe difference between total value and marginal value.Pareto optimality See Economic efficiency.Positive analysis An analysis limited to statements about theactual consequences of an event or policy, with no judgementabout whether the consequences are desirable or not.Positive-sum game In terms of game theory, an interaction inwinnings exceed losses.
Present value Money in the future is less valuable than anequivalent amount of money now because money in the futuregives fewer options. The comparison of money in differenttime periods is made with a present value computation.Price ceiling Legally established maximum price a seller cancharge.Price-discrimination Charging different prices for the samegood or service.Price floor Legally established minimum price a seller can bepaid.Price elasticity of demand Measures how much consumersrespond to a change in price in their buying decisionsPrice elasticity of supply The same formula as price elasticityof demand, except that the quantity in the formula refers to thequantity that sellers will sell.Price searcher A seller (buyer) who can influence price by theamount he sells (buys).Price taker A seller (buyer) who has no control over price, butsells (buys) at the given price.Principal-agent problem The potential conflict of interestwhen a person (the principal) has someone (the agent) acting onhis behalf.Prisonersí dilemma A game theory illustration that self-interest can lead to group disaster.Problem of the commons Refers to the absence of anyautomatic mechanism or incentive to prevent the overuse anddepletion of commonly-held resources.Producers’ surplus The difference between the lowest price aproducer will accept and the actual price. Also called economicrent.Production function The mathematical way of stating thatoutput depends on inputs.Production-possibilities frontier Frontier that separatesoutcomes that are possible for an individual (or a group) toproduce from those that cannot be produced.Profit seeking Efforts to obtain value through exchange byproviding a good or service that others consider valuable. (Seerent seeking for the alternative.)Progressive tax A tax that charges a higher percentage ofincome as income rises.Proportional tax A tax that charges the same percentage ofincome, regardless of the size of income.Public good A good or service that, once produced, has twoproperties: Benefits are available to all and there is no way to barpeople who do not pay (free riders) from consuming the goodor service.Quota Limit on the quantity of a good that may be importedin any time period.Regressive tax A tax that charges a lower percentage ofincome as income rises.Rent seeking Efforts to obtain value through transfer withoutproviding anything in return.
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Scarcity The condition in which human wants exceed theavailable supply of goods, time, and resources. In a worldwithout scarcity, there would be no economics.Shortage The market condition existing when quantitydemanded exceeds quantity supplied. Generally an increase inprice will eliminate a shortage.Speculation Attempting to buy when the price is low and sellwhen it is high.Sunk cost Cost that cannot be recovered.Supply curve The relationship between the quantity sellerswant to sell during some time period (quantity supplied) andprice.Surplus The market condition existing where the quantitysupplied is greater than the quantity demanded. Generally adecrease in price will eliminate a surplus.
Tariff Excise tax on imported goods.Tax incidence Taxes can be shifted from those who write thecheck to the government to others. The study of tax incidence isthe study of who ultimately bears the burden of the tax.Tournament theory An analysis of conditions under whichsmall differences in ability result in large differences in reward.Utility An abstract variable, indicating goal-attainment orwant-satisfaction.Utility function A mathematical way of saying that utilitydepends on consumption of goods and services.Zero-sum game An interaction in which the sum of winningsand losses equals zero.
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REFERENCE MATERIAL
Text Books1. Microeconomics (5th Edition)by Robert S. Pindyck (Author), Daniel L. Rubinfeld (Author)(Hardcover — July 27, 2000)2. Price Theory and Applicationsby Steven E. Landsburg (Hardcover — July 20, 2001)3. Financial Accounting : In an Economic Contextby Jamie Pratt (Author) (Hardcover — February 22, 2002)4. Managerial Economics (5th Edition)by Edwin Mansfield (Editor), et al (Hardcover — February2002)5. Microeconomic Theoryby Andreu Mas-Colell, et al (Hardcover — June 1995)6. Microeconomics: An Integrated Approachby David Besanko (Author), Ronald R. Braeutigam (Author)(Hardcover — September 6, 2001)7. Managerial Economics: Applications, Strategy andTacticsby James R. McGuigan, et al (Hardcover — March 7, 2001)8. Microeconomic Theory: Basic Principles and Exten-sionsby Walter Nicholson (Hardcover — October 26, 2001)9. Foundations of Microeconomicsby Robin Bade (Author), Michael Parkin (Author) (Paperback— July 12, 2001)10. Auction Theoryby Vijay Krishna (Author) (Hardcover — March 1, 2002)11. Introduction to the Mathematics of Financial Deriva-tivesby Salih Neftci (Author), Salih N. Neftci (Hardcover — April2000)12. Microeconomic Analysisby Hal R. Varian (Hardcover — March 1992)13. Health Economics and Policyby James W. Henderson (Paperback — June 27, 2001)14. Intermediate Microeconomicsby Hal R. Varian (Textbook Binding — February 1, 1999)15. Economics, Organization and Management, Theby Paul Milgrom (Author), John Roberts (Author) (Hardcover— February 1, 1992)16. Applied Microeconomicsby Edwin Mansfield (Hardcover — January 1997)17. Forecasting : Methods and Applicationsby Spyros G. Makridakis (Author), et al (Hardcover — Decem-ber 1997)
18. Managerial Economicsby William F. Samuelson (Author), Stephen G. Marks (Author)(Hardcover — April 19, 2002)19. Price Theoryby Milton Friedman (Hardcover — June 1, 1976)20. Principles of Microeconomicsby N. Gregory Mankiw (Paperback — June 6, 2000)
Net SupportIntroductory Economics
Cybernomics: A Semi-Interactive, Almost Multimedia Way toLearn EconomicsAn online principles text by Robert E. Schenk (Saint Joseph’sCollege, IN)The Economics Net-TextBook by Ted Black (University ofMaryland)This online text provides useful simulation and review materialon an extensive collection of micro, macro, and internationaleconomics topics.Essential Macroeconomic Principles by John Bouman (HowardCommunity College)An online macroeconomics text available in either Adobe pdfor Microsoft Word format.Essential Miacroeconomic Principles by John Bouman (HowardCommunity College)An online microeconomics text available in either Adobe pdf orMicrosoft Word format.Essential Principles of Economics: A Hypermedia Approach by RogerA. McCain (Drexel University)The most extensive attempt at an online economics text usinghypermedia.Human Society and the Global Economy by Kit Sims Taylor(Bellevue Community College)This site contains an online version of a survey text in econom-ics that relies on an institutionalist/Post-Keynesian approach.The text may be viewed online or Word 7.0 copies of thechapters may be downloaded.A Pedestrian’s Guide to Economics by Orley Amos (OklahomaState University)An online expanded version of his Economic Literacy book. Thisbook is designed to provide an intuitive explanation ofeconomic concepts to the general public (and strugglingprinciples students).
Introductory MicroeconomicsElements of Economics: The People’s Introduction toEconomic Theory by Richard Ruble (University of Virginia)
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This work is a draft of an introductory/intermediate levelmicroeconomics text.
Intermediate MicroeconomicsPrice Theory: An Intermediate Text, by David FriedmanAn online copy of the text that was published by SouthWesternCollege Publishing.Elements of Economics: The People’s Introduction toEconomic Theory by Richard Ruble (University of Virginia)This work is a draft of an introductory/intermediate levelmicroeconomics text.
International EconomicsInternational Trade Theory & Policy Analysis by Steven M.Suranovic (George Washington University)This web site contains links to a free html version of the text aswell as a pay-per-view version in Adobe Acrobat format. Thefree version does not contain answer keys.
EconometricsHandbook of Econometrics, vol. 1-4Elsevier has now placed the first 4 volumes of the Handbook ofEconometrics online in Adobe pdf format.Structural Analysis of Discrete Data and Econometric Applica-tions, edited by Charles F. Manski and Daniel L. McFaddenThe complete text of this classic 1981 MIT Press volume isavailable in either Adobe PDF or Postscript format.Urban Travel Demand: A Behavioral Analysis by TomDomencich and Daniel L. McFaddenThe entire text of this 1975 North-Holland volume is availableat this site in both Adobe PDF and Postscript formats.
Game TheoryGame Theory Evolving by Herbert GintisThis text provides a dynamic and evolutionary approach togame theory. This text will remain online until its publication byPrinceton University Press in 2000.
Strategy and Conflict: An Introductory Sketch of Game Theory byRoger A. McCainThis online text contains a brief, nontechnical solid introductionto game theory concepts and their application to economics.
Law and EconomicsLaw’s Order: What Economics Has to Do With Law and WhyIt Matters” by David FriedmanThis online copy of a 2000 Princeton University Press textprovides a superb introduction to the relationships between lawand economics. Topics included in this text include economicanalyses of: crime, externalities, marriage, fertility, divorce, thevalue of life, contract law, tort law, and many other topics.
Public ChoiceUnderstanding Democracy: An Introduction to Public Choice by J.Patrick GunningThis text provides a basic introduction to public choice theory.He asks that users of this text provide him with feedback andsuggestions.
Production EconomicsProduction Economics: A Dual Approach to Theory andApplications. Volume I: The Theory of Production, edited byMelvyn Fuss and Daniel L. McFaddenThe entire text of this 1981 North Holland volume is availableonline in either Adobe pdf or Postscript formt.
Public FinancePublic Finance: Government Revenues and Expenditures in the UnitedStates Economy by Randall G. HolcombeThis site provides the complete text (in either .pdf or Wordformat) of the Public Finance text published by West in 1996(currently out of print).
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